Shaping the New Europe: Economic Policy Challenges of EU Enlargement

Shaping the New Europe Economic Policy Challenges of European Union Enlargement

Edited by

Michael A. Landesmann and Dariusz K. Rosati

Shaping the New Europe

Also by Michael Landesmann INDUSTRIAL RESTRUCTURING AND TRADE REORIENTATION IN EASTERN EUROPE (edited with I. Szekely) TRANSFORMING ECONOMIES AND EUROPEAN INTEGRATION (edited with R. Dobrinsky) PRODUCTION AND ECONOMIC DYNAMICS (with R. Scazzieri) UNEMPLOYMENT IN EUROPE (edited with K. Pichelmann) STRUCTURAL DEVELOPMENTS IN CENTRAL AND EASTERN EUROPE THE ECONOMICS OF STRUCTURAL CHANGE (edited with H. Hagemann and R. Scazzieri)

Shaping the New Europe Economic Policy Challenges of European Union Enlargement Edited by

Michael A. Landesmann and

Dariusz K. Rosati

Selection and editorial matter © Michael A. Landesmann and Dariusz K. Rosati 2004 Chapter 6 © Michael A. Landesmann and Palgrave Macmillan Ltd 2004 Chapter 11 © Dariusz K. Rosati 2004 Chapters 1–5, 7–10, 12–14 © Palgrave Macmillan Ltd 2004 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 0–333–97125–6 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Shaping the new Europe: economic policy challenges of European Union enlargement/edited by Michael A. Landesmann and Dariusz K. Rosati. p. cm. Papers in this volume were initially presented at the 25th anniversary conference of the Vienna Institute for International Economic Studies. The theme of the conference was: “Shaping the new Europe: challenges of EU Eastern enlargement – East and West European perpectives” – Preface. Includes bibliographical references and index. ISBN 0–333–97125–6 (alk. paper) 1. Europe, Eastern – Foreign economic relations – European Union countries – Congresses. 2. European Union countries – Foreign economic relations – Europe, Eastern – Congresses. 3. Europe, Central – Foreign economic relations – European Union countries – Congresses. 4. European Union countries – Foreign economic relations – Europe, Central – Congresses. 5. Europe – Economic integration – Congresses. I. Landesmann, Michael A. II. Rosati, Dariusz K. (Dariusz Kajetan) III. Wiener Institut für Internationale Wirtschaftsvergleiche. HF1532.7.Z4E856 2004 330.947—dc22 2003066660 10 9 8 7 6 5 4 3 2 1 13 12 11 10 09 08 07 06 05 04 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

Contents List of Tables

vii

List of Figures

ix

List of Abbreviations

xii

Notes on the Contributors

xiii

Preface

xviii

Introduction Michael A. Landesmann and Dariusz K. Rosati

Part I

1

Macroeconomic Policy Issues

1 Macroeconomic Policy and Institutions during the Transition to European Union Membership William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 2 Exchange Rate Policy in Central and Eastern Europe in the Context of EU Accession George Kopits

27

49

Part II Sectoral Issues: Trade Policies, Competition Policy and Financial Sector Reform 3

European Trade Policies: Clouds on the Horizon? Patrick A. Messerlin

87

4 Preparing for EU Membership: Restructuring the Banking Sector in Hungary György Surányi

103

5 EU Accession and the Evolution and Design of Competition Policy: The Case of Hungary Ádám Török

117

Part III 6

The Economic Effects of Enlargement

Consequences of Accession: Economic Effects on CEECs Michael A. Landesmann and Sándor Richter v

149

vi

Contents

7 The Political Millennium Event: EU Enlargement as an Economic Challenge Fritz Breuss

185

Part IV Experience of Previous Accessions and Lessons for CEECs 8 Lessons to be Learnt from Earlier Accessions Kazimierz Laski and Roman Römisch

219

9

Moving the Escudo into the Euro Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas

246

The Experience of Greece: Delayed Adjustment Loukas Tsoukalis

265

10

Part V

Growing Disparities in Europe

11 The Impact of EU Enlargement on Economic Disparities in Central and Eastern Europe Dariusz K. Rosati

275

12 Prospects for Further (South-) Eastern EU Enlargement: From Divergence to Convergence? Vladimir Gligorov, Mario Holzner and Michael A. Landesmann

315

13 The Impact of EU Enlargement on Countries beyond the New Frontiers Oleh Havrylyshyn

346

Part VI

Political and Economic Challenges

14 Political and Economic Challenges Facing the ‘New Europe’: Contributions by Helen Wallace, Erkki Liikanen, Danuta Hübner, Daniel Daianu, Loukas Tsoukalis, Jim Rollo, András Inotai, Erik Berglöf, Michael A. Landesmann, André Sapir and Ferdinand Lacina

365

Name Index

397

Subject Index

402

List of Tables 1.1 Dimensions of budget characterizations 1.2 Index of centralization for four budget processes 1.3 Fiscal outcomes 2.1 Accession countries, exchange rate and monetary framework, 2001 2.2 Accession countries, selected performance indicators, 1993–99 2.3 Accession countries, selected financial indicators, 1993–99 6.1 Net budgetary positions of the new members after enlargement 6.2 Per capita GDP in selected countries at current PPPs and constant PPPs from 2003 6.3 Hypothetical share of groups of new EU members in transfers from the Structural Funds and the Cohesion Fund, 2007 7.1 The dimensions of EU enlargement: EU and CEEC, 1999 7.2 Integration effects of EU enlargement, Real GDP, 2005–10 7.3 Macroeconomic effects of EU enlargement in selected countries, 2005–10 7.4 Maastricht convergence criteria, candidate countries, 2000–1 8.1 External position of the cohesion countries, 1970–2000 8.2 FDI flows to the cohesion countries, 1970–2000 8.3 GDP per capita, real growth rates, EU-11, cohesion countries, Turkey and United States, 1960–2000 8.4 GDP per capita, in PPS terms, cohesion countries, Turkey and United States, 1960–2000 8.5 Per capita GDP, 1950–2002 8.6 Per capita GDP in the accession countries, according to WIIW estimates 2002 8.7 Growth of per capita GDP in the accession countries and EU-15, 1989–2002 8.8 Number of years needed by the accession countries to reach 75 per cent and 100 per cent of the EU-15’s per capita GDP 9.1 Chronology of the ERM crisis regime from entry to the first realignment 9.2 Chronology of the ERM crisis regime from the first realignment to the widening of the bands vii

35 36 37 54 55 64 151 160

162 191 194 208 210 224 231 236 237 238 241 241

242 254 256

viii List of Tables

9.3 9.4

Comparisons relative to constant variance model Average standard deviation and probabilities of states in regimes 10.1 Main economic indicators: long-term trends, 1961–2002 11.1 EU and Central and Eastern Europe, population, per capita GDP and distance from Brussels, 2000 11.2 Selected economic and human development indicators, EU and CEE countries, 1997 11.3 Progress of institutional reforms in the CEE countries by membership of international organizations as of June 2002 11.4 Growth performance of the EU and CEE countries 11.5 Potential for instability in the CEE countries according to the PIN index value, 2000 11.6 Inflation and budget deficits in Central and Eastern Europe, 2001 11.7 Average annual FDI flows to the new EU member countries and share of total FDI flows to the EU and OECD countries before and after accession 11.8 Transition countries, regional shares in trade, 1997 12.1 Basic indicators, SEE and CEE countries, 2002 12.2 Labour market indicators, SEE and CEE countries, 2002 12.3 Foreign direct investment by sector, CEE and SEE countries, 2001 12.4 Balance of payments structure, South-East Europe, 2001 12.5 Private transfers, South-East Europe, 2000–1 12.6 Shadow economy, SEE and CEE countries, 1999–2000 12.7 External debt indicators, South-East Europe, 2001–3 12.8 General government data, South-East Europe, 2001–3 12.9 General government spending on wages and salaries, South-East Europe, 2001–3 12.10 Subsidies and transfers, South-East Europe, 2001–3 13.1 Basic economic data and exports to EU, 2001 13.2 Trade flows, CIS, Baltic and CEE countries, 2001 13.3 Product composition of exports to the EU, 2000, SITC 1 digit product codes, percentage of EU imports from each country

260 261 266 278 280

285 287 289 291

299 306 316 318 321 323 324 332 334 336 337 338 347 350

353

List of Figures 1.1 1.2 2.1 2.2

Policy reaction to an investment boom Policy matrix Trade with the European Union, selected countries, 2000 Distribution of value added and labour force, selected European countries, 1998 2.3 Exchange rate and unit labour costs, Poland, 1993–98 2.4 Exchange rate and unit labour costs, Slovenia, 1993–98 2.5 Exchange rate and unit labour costs, Hungary, 1993–98 2.6 Exchange rate and unit labour costs, Czech Republic, 1993–98 2.7 Exchange rate and unit labour costs, Estonia, 1994–97 2.8 Exchange rate and interest rates, Poland, January 1997 to February 1999 2.9 Exchange rate and interest rates, Czech Republic, January 1997 to February 1999 2.10 Exchange rate and interest rates, Hungary, January 1997 to February 1999 2.11 Exchange rate and interest rates, Slovenia, January 1997 to January 1999 2.12 Exchange rate and interest rates, Estonia, January 1997 to January 1999 3.1 MFN and Europe Agreement tariffs, Czech Republic, Poland and EU, 1991–2000 3.2 Preferential average concessions, Czech Republic, Poland and EU, 1991–2000 5.1 Volume of the Competition Council’s caseload, 1991–2002 5.2 Structural changes in the Competition Council’s caseload, 1991–2002 5.3 Cases of consumer deception, 1991–2000 6.1 GDP deflator, 1996–2002 6.2 Interest rates, 1998–2002 6.3 Budget balance, 1998–2002 6.4 Real exchange rates, January 2000 to January 2003 6.5 Growth of GDP, manufacturing production, employment and productivity in the accession countries and the EU, 1994–2002 6.6 GDP, 1995–2002 6.7 Change in market shares, 1995–2001: (a) by industry categories in enlarged EU trade; (b) by skill categories in enlarged EU trade ix

40 46 52 53 61 61 62 62 63 67 68 69 70 71 91 94 122 123 128 164 165 167 173

176 177

179

x List of Figures

7.1 7.2 7.3 7.4 7.5 7.6 7.7 8.1 8.2 8.3 8.4 8.5 8.6 10.1 10.2 10.3 10.4 10.5 11.1 11.2 11.3 12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9

Overall integration effects (real GDP) of EU enlargement: (a) EU; (b) CEEC, 2001–10 Inflation convergence in the EU in the run-up to EMU, 1999–2002 Increased inflation volatility due to EU enlargement, 2001–10 GDP growth convergence in the EU in the run-up to EMU, 1992–2002 Estimated increase in GDP growth volatility due to EU enlargement, 2001–10 Budgetary convergence in the EU in the run-up to EMU, 1992–2002 Increased current account divergence in the EU in the run-up to EMU, 1992–2002 GDP and capital inflows Cohesion country exports as percentage of imports, 1960–2000 FDI stocks in relation to GDP, 1980–2000 Per capita GDP at PPS Per capita GDP, 1950–2002 Difference between per capita GDP in selected countries and that in the EU-10, 1950–2002 Convergence of Greece with the EU: inflation and budget deficits, 1993–2001 Growth rates in Greece and EU-15, 1993–2002 Trade openness, Greece and EU-15, 1981–2002 Intra-EU trade goods only, 1981–2000 Trade balance and transfers, EU and Greece, 1981–2000 Relationship between the distance from Brussels and per capita GDP for 32 European countries, 2000 Membership index and distance from Brussels of 17 CEECs, 2002 EBRD index of institutional reforms and distance from Brussels of 17 CEECs, 2002 Real GDP, CEE and SEE countries, 1990–2002 Employment levels, CEE and SEE countries, 1990–2001 Exports from CEE and SEE countries, 1990–2001 Per capita FDI stock, CEE and SEE countries, 1990–2001 Current account, SEE and CEE countries, 2002 Trade balance, SEE and CEE countries, 2001 GDP structure, SEE and CEE countries, 2001 Employment structure, SEE and CEE countries, 2001 Labour productivity in industry, CEE and SEE countries, 1990–2001

201 204 205 206 206 207 207 221 229 232 237 239 240 267 268 269 269 270 283 285 286 317 317 319 320 322 322 325 325 327

List of Figures xi

12.10 Average monthly gross wages, CEE and SEE countries, 1990–2002 12.11 Unit labour costs, CEE and SEE countries, 1990–2002 12.12 Indicators of competitiveness, SEE and CEE countries, 2001 12.13 Exports to the EU: (a) technology-driven industries; (b) marketing-driven industries; (c) capital-intensive industries; (d) labour-intensive industries; (e) mainstream industries, 1997–2001 12.14 Exports to the EU: (a) high-skill industries; (b) medium-skill/white-collar industries; (c) medium-skill/blue-collar industries; (d) low-skill industries, 1997–2001

327 328 328

329

330

List of Abbreviations CAP Common Agricultural Policy CCP Common Commercial Policy CEECs Central and East European Countries CEFTA Central European Free Trade Agreement CIS Commonwealth of Independent States CMEA Council for Mutual Economic Assistance CPI Consumer Price Index EBRD European Bank for Reconstruction and Development ECB European Central Bank ECOFIN Council for Economic and Financial Affairs EMU European Monetary Union ERM Exchange Rate Mechanism ECSC European Coal and Steel Community FDI Foreign Direct Investment GATT General Agreement on Tariffs and Trade GNI Gross National Income MAFAS Multi-Annual Fiscal Adjustment Strategy MFN Most Favoured Nation NTB Non-Tariff Barrier OCA Optimum Currency Area OEC Office of Economic Competition, Hungary PPERR Pre-Pegging Exchange Rate Regime PPP Purchasing Power Parities PTA Preferential Trade Agreement SGP Stability and Growth Pact ULC Unit Labour Costs WTO World Trade Organization

xii

Notes on the Contributors Erik Berglöf is Director of the Stockholm Institute of Transition Economics and East European Economies (SITE) at the Stockholm School of Economics and a research fellow at the Centre for Economic Policy Research, London. He has also served as an assistant professor at the European Centre for Advanced Research in Economics, Free University of Brussels, and held a visiting position at Stanford University. He has served on various EU-related panels and is currently Project Director of RECEP, an EU-financed research institute in Moscow. He has written extensively on financial contracting and corporate governance. Jorge Braga de Macedo is Special Advisor to the Secretary General of the OECD, Paris. He is also an associate professor at the Institut d’Études Politiques, Paris, Professor of Economics at Nova University in Lisbon, a research associate at the National Bureau of Economic Research in Cambridge, Mass., and a research fellow at the Centre for Economic Policy Research, London. Previously he was Director for National Economies at the European Commission (1988–91), Minister of Finance in Portugal (1991–93), President of the Parliamentary Committee on European Affairs (1994–95) and President of the OECD Development Centre (1999–2003). He has published widely on European integration, monetary and development economics. William H. Branson is the John Foster Dulles Professor of International Affairs at Princeton University, Director of Research in International Studies at the NBER and a research associate at the Centre for Economic Policy Research. He has been a visiting professor at many universities and a visiting scholar in several international organizations, including the IMF, the World Bank and the Banca d’Italia in Rome. His publications, which are mostly on macroeconomic theory and policy, include a well-received macroeconomic text. Fritz Breuss is Jean Monnet Professor of Economics at the University of Economics and Business Administration in Vienna (Research Institute for European Affairs) and a research economist at the Austrian Institute of Economic Research (WIFO). Previously he was a visiting scholar at the University of Cambridge and the University of California at Berkeley. His recent publications include papers on the Austrian economy and European economic integration. Francisco Covas is a fourth-year PhD student at the University of California, San Diego. He completed his undergraduate studies at Faculdade de Economia Universidade Nova de Lisboa, and then worked in the Research xiii

xiv Notes on the Contributors

Department of the Banco de Portugal and the Instituto Nacional de Estatística before starting his graduate studies. Daniel Daianu is Professor of Economics at the Academy of Economic Studies in Bucharest, Romania, Chairman of the Romanian Economic Society and President of the European Association for Comparative Economic Studies. In 1998 he was Finance Minister of Romania, and before that Chief Economist at the National Bank of Romania. He has been a lecturer, research fellow and visiting professor at, inter alia, Harvard University, the Wilson Center in Washington, DC, the Anderson School of Business, University of California, Los Angeles, the IMF, the NATO Defence College in Rome and the United Nations Economic Commission for Europe. His publications cover a wide variety of issues related to European integration and economic transformation. Vladimir Gligorov is Senior Economist at the Vienna Institute for International Economic Studies (WIIW). Previously he was a research economist at the Institute for Economic Sciences in Belgrade and a visiting fellow at the Centre for the Study of Public Choice, George Mason University, and at Uppsala University. His most recent publications include several articles on Yugoslavia and the economic transformation of Central Europe and Russia. Oleh Havrylyshyn has served on the Board of Directors of the IMF and as Deputy Director of the European II Department. He has also served as a consultant to various governments, the World Bank and other international agencies. In 1992 he was Deputy Minister of Finance in Ukraine. He is currently a visiting scholar at the Centre for Russian and East European Studies, University of Toronto. He has published numerous journal articles and books on international economics and finance. Mario Holzner is a staff economist at the Vienna Institute for International Economic Studies (WIIW) and a PhD student at the Vienna University of Economics and Business Administration. His research focuses on various aspects of the economic transformation of South-East Europe. Danuta Hübner is Minister for European Affairs, Warsaw. Previously she worked as Undersecretary General of the UN and as Deputy Executive Secretary of the UN Economic Commission for Europe, and was Minister and Head of the Chancellery of the President of the Republic of Poland. She conducted the negotiations for Poland’s accession to the OECD in November, 1996. She is Professor at the Warsaw School of Economics since 1981 and has published numerous articles on the growth of the Polish economy. András Inotai is Director General of the Institute for World Economy in Budapest. From 1996 to 1998 he was head of the Strategic Task Force on Integration into the European Union, and from 1989 to 1991 he worked at the Trade Policy Division of the World Bank. He has also been a visiting

Notes on the Contributors xv

professor at San Marcos University in Peru. His recent publications focus on international economics and regional integration. George Kopits is a member of the Monetary Council of the National Bank of Hungary. Formerly he was Assistant Director of the Fiscal Affairs Department at the IMF. From 1997 to 1998 he was a visiting fellow at the University of Siena, the University of Vienna and the Vienna Institute for International Economic Studies (WIIW). From 1993 to 1996 he was Senior Resident Representative of the IMF in Hungary. He has published many articles on economies in transition, European economic integration and monetary policy. Ferdinand Lacina is President of the Vienna Institute for International Economic Studies and a consultant to Bank Austria Creditanstalt. As a member of the Austrian government he has served as Federal Minister for Transport, Federal Minister for Public Economy and Transport and Minister of Finance. Michael A. Landesmann is Research Director of the Vienna Institute for International Economic Studies (WIIW) and Professor of Economics at Johannes Kepler University, Linz. Previously he was a fellow of Jesus College and a senior research economist in the Department of Applied Economics at the University of Cambridge. He is a member of the Economic Analysis group of economic advisors to the President of the European Commission. Kazimierz Laski is a research associate at the Vienna Institute for International Economic Studies (WIIW) and Emeritus Professor of Economics at Johannes Kepler University, Linz. From 1991 to 1996 he was the Research Director of WIIW, prior to which he was Professor and ViceRector at the Central School of Planning and Statistics, Warsaw. His recent publications have been on the theory of economic transformation and a transition strategy for Central and Eastern Europe. Erkki Liikanen is Commissioner for enterprise and information society; in the previous Commission, he was Commissioner for budget and administration. He is a former member of the Finnish parliament and has also served as Finance Minister. From 1990 to 1994 he was the Finnish Ambassador to the European Union. Patrick A. Messerlin is Professor of Economics at the Institut d’Etudes Politiques de Paris and Director of the Groupe d’Economie Mondiale de Sciences Po. He has worked as a senior economist at the World Bank and has been a visiting professor at the University of Houston and Simon Fraser University in British Columbia. His publications include articles on European economic integration, general trade policy and EU trade policy. Luís Catela Nunes received his PhD in Economics from the University of Illinois at Urbana Champaign and then joined the Economics Faculty at the Universidade Nova de Lisboa, where he is currently Professor of

xvi Notes on the Contributors

Econometrics. His research on theoretical and applied econometrics has been published in several journals. Sándor Richter is Senior Economist at the Vienna Institute for International Economic Studies (WIIW). Previously he was managing director of Echo Consulting in Budapest and a research economist at the Institute of Economics, Hungarian Academy of Sciences. He has published works on the Hungarian economy, international trade and regional integration. Jim Rollo is Professor of Economics and Director of the Sussex European Institute, University of Sussex. Previously he was Chief Advisor at the British Foreign Office and has been a visiting professor of economics at Nottingham University. Between 1989 and 1993 he held a number of UK government posts and was Director of Economics at the Royal Institute of International Affairs. He has published widely on international economic issues, principally in the field of trade policy and the European Union. Roman Römisch is a staff economist at the Vienna Institute for International Economic Studies (WIIW). His main fields are regional economic development in Central and Eastern Europe and macroeconomic analysis. Dariusz K. Rosati is Professor of Economics at the Warsaw School of Economics and a member of the Monetary Policy Council at the National Bank of Poland. He has been a member of the Government Socio-Economic Strategy Council, and from 1995 to 1997 he served as Minister of Foreign Affairs of the Republic of Poland. His publications deal with economic policy, financial analysis, international economics and economic transformation. André Sapir is Professor of Economics at the Université Libre de Bruxelles (ULB), where he holds a chair in international economics and European integration. He is member of ECARES (the European Centre for Advanced Research in Economics and Statistics) and former President of the Institut d’Etudes Européennes. Sapir is also a research fellow of CEPR (the Londonbased Centre for Economic Policy Research) and has served for a number of years as Economic Advisor to the Director-General for Economic and Financial Affairs of the European Commission, and more recently the President of the Commission. Previously he was Assistant Professor of Economics at the University of Wisconsin, Madison. André Sapir has published extensively on international economic relations, mainly trade policy, international monetary issues and enlargement. György Surányi is Head of Central and East European Region operations at the Banca Intesa in Italy, and Professor of Finance at the Budapest University of Economics and the Central European University. He has also served as Governor of the National Bank of Hungary and as a CEO of the Central European International Bank. His publications include articles on monetary policy and finance.

Notes on the Contributors xvii

Ádám Török is a member of the Hungarian Academy of Sciences, Professor of Economics at the University of Veszprém and the Budapest University of Technology and Economics, and a permanent visiting professor at the Central European University. He is also Vice-President of the Hungarian Economic Association and Editor-in-Chief of Acta Oeconomica. He has extensively published on enterprise development in the transition, competition policy and technology policy. Loukas Tsoukalis is the Jean Monnet Professor of European Organization at the University of Athens, a professorial fellow at the Robert Schuman Centre, European University Institute, Florence, and President of the Hellenic Foundation for European and Foreign Policy. He has taught at Oxford University, the London School of Economics and the College of Europe in Bruges. He has also been active in public policy and the private sector. He has written many books and articles on European integration and foreign economic policy. Jürgen von Hagen is Professor of Economics and Director of the Centre for European Integration Studies, University of Bonn. He has held professorial appointments at the University of Indiana and the University of Mannheim, where he was also Director of the Institute for Advanced Studies. He is a research fellow at the Centre for Economic Policy Research, London, and has published widely on macroeconomics and European monetary integration. Helen Wallace is Director of the Robert Schuman Centre for Advanced Studies, European University Institute, Florence. Previously she was Director of the Sussex European Institute at the University of Sussex, Jean Monnet Professor of Contemporary European Studies and Director of the UK Economic and Social Research Council’s programme ‘One Europe or Several?’. Her research and publications explore decision-making processes and governance in the European Union.

Preface The papers gathered in this volume were originally presented at the 25th Anniversary Conference of the Vienna Institute for International Economic Studies (WIIW). The theme of the conference, ‘Shaping the New Europe: Challenges of EU Eastern Enlargement – East and West European Perspectives’, has been at the forefront of the WIIW’s research agenda since the mid 1990s and is only the latest chapter in its long and distinguished history of monitoring developments in Central and Eastern Europe. With the imminent accession of 10 new member countries the topic is even more relevant now than it was at the time of the conference. The papers have been updated, and in some cases completely revised, to take into account the shifting circumstances of, discussions on and concerns about EU enlargement. To give some flavour of the lively discussions that took place at the conference and in order to show how eminent social scientists and policy makers viewed the main issues, an edited selection of contributions to the panel discussions are presented at the end of the book. We are indebted to Eva Strobl for her patience and professionalism in assisting us with the editorial work for this book, and to Sabine Grob for her editorial assistance. We also drew on the expert skills of the statistical staff at the WIIW and we would like to thank them for their contribution. We dedicate this volume to Professors Friedrich Levcik and Kazimierz Laski, the former Scientific Directors of the WIIW who established the institute’s high standards and intense commitment to issues of policy, and to Dr Ingrid Gazzari, whose strong and steady leadership as Administrative Director has been the soul of the institute since its inception. MICHAEL A. LANDESMANN DARIUSZ K. ROSATI

xviii

Introduction Michael A. Landesmann and Dariusz K. Rosati

The European Union (EU) will soon admit new members from Central and Eastern Europe: accession negotiations with ten candidate countries were finalized at the EU summit in Copenhagen in December 2002, thus paving the way for their admission on 1 May 2004 when they have completed the process of ratifying their accession treaties. The summit also determined some key conditions for accession, and in particular the level and structure of the financial obligations of old and new members. Of course not all questions pertaining to enlargement were answered at the summit. For example, what impact will elimination of the remaining barriers to trade and resource flows have on the economies of the old and new members? What response should there be to potentially negative effects of economic liberalization and increased competitiveness in the EU labour markets and other sensitive sectors? Will the new member countries be able effectively to enforce the acquis communautaire in their legal and institutional systems? Are they ready to absorb the structural funds that have been put at their disposal? What can be done to ensure effective economic governance in an enlarged EU that encompasses a much more diverse economic area and countries with distinctly lower levels of economic development? When should the new members join the European Monetary Union (EMU)? What impact will enlargement have on countries that are not candidates for membership? Is there a risk of new divisions in Europe? The purpose of this volume is to identify some of the most important challenges posed by the enlargement and to discuss possible policy responses. While it is commonly accepted that on balance the enlargement should bring substantial benefits to old and new members alike, the process is far from uncontroversial. It involves hopes but also worries. Both the incumbents and the new members have to prepare themselves for the enlargement in terms of institutional changes and policy adjustments in order to ensure that it will not entail unnecessary costs and will bring the much hoped for benefits. The papers collected in this volume examine the challenges of enlargement in four broad areas: the economic impact on the 1

2

Introduction

old and new EU member states, the role of institutions, macroeconomic policy issues related to monetary integration and to the functioning of the enlarged EMU, and the impact of enlargement on non-candidate countries.

Economic costs and benefits A number of studies have been conducted on the economic implications of EU enlargement (for example Baldwin et al., 1997; Brown et al., 1997; Keuschnigg and Kohler, 1999; Breuss, 2001; EU Commission, 2001; Boeri et al., 2002; Boldrin and Canova, 2003). The key conclusion to emerge from these works is that enlargement is likely to produce considerable economic benefits for the EU-15 and the accession countries. Depending on the methodology used, estimates of the economic gains to be expected from enlargement in terms of the cumulative increase of GDP range from 0.5 per cent to 0.7 per cent for the EU-15 as a whole and from 6 per cent to 19 per cent for the new members in the first ten years after accession. These gains include both the static and the dynamic effects of integration. In Chapter 7 Fritz Breuss uses a world macroeconomic model to calculate the extent of three effects of integration: trade effects, single market effects and factor movement effects. His results broadly confirm the earlier finding that enlargement is essentially a ‘win–win’ game, although the new member countries are likely to gain relatively more than the older members because of the relatively modest size of their economies. The total benefits that will accrue to the Czech Republic, Hungary and Poland will be in the range of 6–9 per cent of GDP over the next decade, while those accruing to the incumbent EU countries will amount to 0.2–0.3 per cent of the EU’s total GDP. While these predictions are obviously sensitive to underlying assumptions about, inter alia, the level of financial transfers to the new members and the degree of labour market flexibility, the general finding that significant economic gains will be had from enlargement is quite robust. There is more uncertainty about the effects of EU enlargement on third countries that are not included directly in the process. Drawing on the studies by Baldwin et al. (1997) and Winters (1997), in Chapter 13 Oleh Havrylyshyn estimates these effects for an important group of third countries – the CIS countries. He distinguishes three main channels of economic interchange through which positive and negative effects might be felt: trade flows, capital flows and labour and human capital flows. He finds that, for trade flows, the net effect of trade creation and trade diversion for 12 CIS countries is a small net loss of 1.3–1.4 per cent of their export values. With regard to investment flows, and particularly foreign direct investment (FDI), the enlargement could lead to a diversion of FDI inflows to new members and away from the CIS countries. Similarly, migration policies in the enlarged EU may result in more restrictions in the movement of people between the

Michael A. Landesmann and Dariusz K. Rosati 3

EU and the CIS countries, with particularly harmful effects on temporary labour flows. Havrylyshyn warns that while it is very difficult to estimate the impact of EU enlargement on resource flows, it is likely to be negative. Another finding of the enlargement literature is that a number of potential problems and risks are involved in the enlargement process. Among those most frequently mentioned is the risk of mass migration after the borders are opened to new members, resulting in increased pressure on the labour markets and national welfare systems of old members, a high budgetary cost in terms of EU transfers to new members, the risk of industrial relocation to new members (including FDI diversion), and the risk of a sharp reduction of Structural Fund transfers to the old cohesion countries in the EU-15 as a result of these funds being rechannelled to the new members. Such problems may arise either as a consequence of the complete elimination of the remaining barriers to the free flow of goods, services and production factors within the enlarged Europe (the extension of the ‘four freedoms’ of the European Single Market to new member), or from including new members in EU common policies, mostly the Common Agricultural Policy (CAP) and structural/regional policies and – at a later stage – the single monetary policy within EMU. As most of these problems are only likely to materialize – if at all – after the enlargement takes place in 2004, studies on the subject differ widely in their estimates of the scope and level of risks involved, and in their predictions of the nature and design of recommended policies. The various economic implications of enlargement are not independent from each other. Rather they can be seen as representing various aspects of one core problem – the existence of large per capita income differentials between the EU-15 and the new members. Fear about the mass migration of people from the new member countries is based on the assumption that the much higher wages and better social welfare in the EU-15 countries will induce many to migrate. Massive budgetary transfers from the EU-15 to new members are inevitable under the current EU structural and cohesion policies, which are mainly driven by disparities in income levels in individual regions and countries. In order to secure sufficient resources to channel to the new members, funds that at present go to the EU cohesion countries are likely to be reduced (though only gradually). Finally, the expected increase in FDI flows to the new members, which may also involve the exportation of some jobs from the EU-15, will be at least partly motivated by the lower manpower costs in the new member countries. Of course the large per capita income differentials between the old and new members means that policies aimed at ensuring speedy income convergence should be a key priority when designing the post-enlargement EU economic strategy. This issue and the two other most debated issues – migration and regional policies – will be discussed in the following subsections.

4

Introduction

Income convergence The income disparities between the old and new member countries are substantial. At purchasing power parity (PPP), in 2000 the average per capita income in the new member countries stood at 32 per cent of the EU-15 level. This average masks important differences between countries, with income levels varying from 22 per cent of the EU average in Latvia to 70–75 per cent in Slovenia and Cyprus. These disparities are greater than they were for Greece, Portugal and Spain (the Mediterranean-3) when they were about to join the EU in the 1980s (approximately 60 per cent of the EU average). More importantly, neither theory nor the experiences of earlier enlargements convincingly supports a hypothesis of automatic convergence. Rather, research suggests that poorer countries or regions are characterized by lower steady-state levels and that convergence applies more to transitory higher growth rates than to income levels (Barro and Sala-i-Martin, 1995). As Kazimierz Laski and Roman Römisch discuss in Chapter 8, lessons from earlier enlargements suggest that the catching-up process is generally very slow, and even if it is successful in relative terms it does not necessarily diminish the absolute differences in incomes between countries. Of course there are exceptions, and Ireland is often cited as a successful example of catching up. However in many respects this case is unique and atypical, and probably will not be fully emulated by the next group of new members. The Mediterranean 3 have converged somewhat, but not as much and as rapidly as expected. Disappointing cases such as the Mezzogiorno region in Italy, Greece during its first 15 years of membership (see Chapter 10) and the eastern Länder in Germany demonstrate that convergence may not occur for many years, even when supported by massive financial transfers. As noted by Dariusz Rosati in Chapter 11, it is difficult to detect any income convergence by the new member countries to the EU levels in the posttransition period up to 2000 (except perhaps for Poland and Estonia). These varying performances suggest that there is nothing automatic about convergence, and that it may occur only in the presence of certain key growth factors. Identification of these factors and assessment of the extent to which they are present in the new member countries is necessary to determine whether these countries are equipped for rapid and sustained growth. Mainstream growth theory has traditionally concentrated on physical and human capital accumulation, labour and technological progress. More recent contributions have emphasized the role of non-standard factors, such as institutions and the rule of law. It may be useful to have a quick glance at those factors. The stock of physical capital in the new member countries is inadequate in terms of the needs of economies that open up to international competition. Their investment rates are relatively high at 24–25 per cent on average, compared with 18 per cent in the EU, but also high are the depreciation rates of obsolete capital stock inherited from the old system, and their investment

Michael A. Landesmann and Dariusz K. Rosati 5

structures tend to be concentrated in low- and medium-techology sectors, meaning high capital to output ratios and a lower total factor productivity (TFP) effect. Furthermore public investment in infrastructure is inadequate. To ensure rapid GDP growth, these countries’ investment rates will have to remain at relatively high levels. One important facet of capital endowment that is particularly underdeveloped in the new member countries is physical infrastructure, especially in the case of transport. As the development of infrastructure is one of the main objects of the EU regional/structural policies, these countries can expect to receive substantial support for infrastructural projects. Progress in this area is urgently needed and resources transferred from the Cohesion and Structural Funds can be expected to yield very high external benefits. Investment efficiency and productivity levels are strongly enhanced by FDI, which is commonly viewed as an essential factor in growth and technological progress in catching-up countries (affecting growth through increases in capital endowments and TFP). FDI inflows to the new member countries in the recent past were very high compared with those to the Mediterranean-3 in the 1980s (3–6 per cent of GDP versus 1–3 per cent), though the geographical distribution was not uniform and some of the flows were directed at acquisitions under privatization programmes that are soon to be phased out. But after the peak in 2000 the flows substantially declined, reflecting deteriorating global trends and less privatization. Is it possible that FDI flows will recover or even increase? Some observers are quite positive about the prospect (for example Boeri et al., 2002, predict a doubling of FDI after accession), but will this expansion come as a result of EU accession only, or will it require specific policies by the new members? Inflows of foreign capital may also involve some risks. In Chapter 8 Kazimierz Laski and Roman Römisch argue that standard analyses of the effects of foreign capital inflows typically concentrate on supply-side effects and demand-side effects tend to be disregarded. Meanwhile strong foreign capital inflows, especially in financial form, lead to a real appreciation of the domestic currency and produce important shifts in total demand in favour of imports and against exports. If this response is large enough, the resulting loss of jobs may in some instances exceed any positive effects of FDI on the domestic economy. Certainly, EU accession can be expected to make the new member countries a magnet for foreign investors from the other EU countries and elsewhere as investors will be able to exploit the generally low production costs and free access to a market of nearly 450 million consumers. But actual flows and their distribution among these countries will strongly depend on the policy environment. Under EU law, many FDI-supporting financial measures such as tax breaks and discriminatory treatment will no longer be allowed, and the new members will have to adopt policies that do not contradict the EU rules on competition and public aid. These policies should

6

Introduction

concentrate on establishing a business friendly administrative and legal environment, and on promoting the countries in question as areas that can offer competitive and educated manpower. FDI from the older EU members could involve the relocation of production from themselves to the new members, with a consequent loss of jobs, but in most cases this is unlikely to happen. First, such relocation would be efficiency-enhancing and in the longer term would benefit the whole EU. The older EU members can be expected to put their free resources into higher value-added sectors, thus moving up the technology ladder and improving their competitiveness in the longer term. They are also likely to benefit from substantial spillover effects of FDI in the new members. If some social costs are involved in the process of restructuring, they can and should be alleviated through regional and structural aid. In general, then, the efficiencyenhancing reallocation fostered by enlargement must not be hampered. Second, it is difficult to demonstrate that firms in the old EU countries would not relocate their production if the accession countries were not admitted to the EU after all; it is very likely that such shifts would take place anyway, probably to non-EU developing countries with lower production costs than even the new members would have been able to offer. Moreover FDI includes new investment in response to new opportunities, and not just the simple relocation of existing activities. The experience of earlier enlargements demonstrates that increased FDI inflows to new members such as Spain, Portugal, Greece and Ireland were not accompanied by a significant decline in investment ratios in the old member countries. Investment in the new member countries by EU and non-EU firms may come at the cost of investment in third countries, especially the CIS countries and the Balkan states. This could entail a loss of growth potential in those countries. In Chapter 13 Oleh Havrylyshyn argues that while the risk of this is substantial, the CIS and Balkan countries will still able to attract additional FDI flows by further reforming their economic systems, strengthening the rule of law and offering a business-friendly environment. Human capital is essential for rapid and sustained growth. Better educated people are generally more productive and more innovative than less educated people. Also, better educated people generally tend to be healthier and more law-abiding, thus reducing the demand for certain costly public goods (health care, law and justice). Hence human capital contributes both directly and indirectly to economic growth. How do the new member countries rate in this respect? Official statistics suggest that their human capital is relatively well developed as they have high levels of elementary and secondary education (probably higher than in the Mediterranean-3 in the 1980s). However as pointed out by András Inotai in Chapter 14, they have problems with skills mismatch, curricula contents and the scope of tertiary education. Also, the apparent lack of life-long learning and retraining programmes makes the labour supply less flexible and less productive.

Michael A. Landesmann and Dariusz K. Rosati 7

EU assistance in these areas would be helpful. Regional and structural policies could be used to finance projects aimed at enhancing human capital, focusing in particular on eliminating mismatches in skills and establishing facilities for life-long learning, the acquisition of new skills and vocational training. Support also should be given to the further development of tertiary education, preferably in cooperation with Western educational institutions (programme validation and exchanges) and with more extensive coverage of the new member countries by EU programmes (Socrates, Erasmus, Leonardo and so on). The modernization of curricula and increased opportunities for educational cross-border exchanges will be crucial to the improvement of higher education systems in these countries. With regard to the inclusion or exclusion of the CIS and Balkan countries in such cross-border exchanges, in Chapter 13 Havrylyshyn emphasizes that this will be an important factor in whether these non-EU countries will experience a widening of their differential positions vis-à-vis the new member countries. Migration The issue of migration has gained prominence in the context of accession because of concern about the effects that mass migration from the new member countries would have on labour markets and incomes in the old member countries. This issue has been examined by a number of authors using a variety of approaches, including simple extrapolation exercises, historical analogies, static and dynamic models and error-correction models (see Boeri et al., 2002, for a review). Their results differ widely, which is not surprising given the number of necessary assumptions and the long-term nature of the exercise. In the event of full liberalization of cross-border labour movement immediately after EU enlargement, estimates of the annual flow of migrants from the new member countries in Central and Eastern Europe (the CE-8) range from 250 000 to 450 000 in the first one or two years and falling to some 100 000 to 200 000 thereafter. Over the next decade the cumulative number of migrants would amount to between 1.5 and 4.0 million, that is 2–4.5 per cent of the total population of the CE-8 or 0.4–1.2 per cent of the total population of the EU-15. Even though we cannot be certain about the accuracy of these figures, they are small relative to the size of the workforce in the EU. Moreover there is evidence to suggest that the actual figures may be even smaller. First, the experience of earlier enlargements shows that migration depends not only on income differentials but also on job opportunities and numerous cultural and social factors. After all the income differentials between the CE-8 and the EU were several times larger in the early 1990s than they are now and there was no sign of mass migration. Second, a sizeable fraction of people who are inclined to migrate might already have done so as around 300 000 Central and Eastern European nationals are working in the EU, despite the strict restrictions on labour mobility. Overall the relatively insignificant

8

Introduction

inflow of workers from the new member countries will probably not cause significant perturbations of the EU labour markets in terms of overall job opportunities and the impact on wages. Maintaining EU-wide restrictions beyond 2004 will therefore not be required or justified. However, while there is no problem with the absolute number of wouldbe migrants, the same probably cannot be said of their geographical distribution. Migration is likely to be heavily concentrated in countries that border the CE-8 region, particularly Germany and Austria. At the moment two thirds of migrants from the CE-8 countries reside in Germany and 14 per cent in Austria, accounting for 0.5 per cent and 1.1 per cent of the workforce respectively. The estimates of net migration to Germany in the initial years after enlargement vary widely, ranging from 70 000 (Fertig, 1999) to 2–300 000 (Sinn et al., 2001) a year, but declining in subsequent years. If the upper bound is accepted as likely, migrants from the region would make up 2–3 per cent of the German population after 15–20 years. This brings us to the policy question of how best to respond to the risk of mass migration. The most popular recommendation is to maintain restrictions on migration for a transitional period until the income gap narrows and the incentive to migrate is reduced. During the accession negotiations the incumbent EU members as a group granted themselves the option of applying restrictions for three years and extending them for another four years if necessary, but some members – including Sweden, Spain and the UK – have since stated that they will remove all restrictions on the free movement of labour immediately after enlargement takes place in 2004. In contrast Germany and Austria have made it clear that they will opt for a transitional period. As observed by Ferdinand Lacina in Chapter 14, the guarded approach to potential migration exhibited by some EU countries is rooted in strong political presure by organized labour groups that have long campaigned against the opening up of EU labour markets. This is hardly surprising given the traditional focus on the protection of high wages and welfare standards in European countries, but there have also been attempts to justify this approach on the ground of uncertainty. It is argued that since the size of future migration flows is highly uncertain there is value in postponing the full liberalization of labour movements (Boeri et al., 2002). This argument is questionable. Postponement will not allow us to gain a better idea of the likely magnitude of migration as it will simply perpetuate the status quo, and whatever the eventual magnitude, most studies have found that the impact on jobs and wages in the EU will be very moderate. Moreover as the inflows are likely to be concentrated in certain countries or regions the appropriateness of EU-wide restrictions on labour mobility is thrown into doubt. Imposing such measures would prevent many EU regions and sectors from exploiting the opportunities offered by an expanded skills base and labour supply. After all, as economic theory

Michael A. Landesmann and Dariusz K. Rosati 9

suggests, the integration of economies at vastly different levels of development calls for increased interindustry and interregional labour mobility. An alternative way of addressing the problem would be to apply safeguard clauses. The EU-15 and CE-8 countries could agree that no restrictions would be imposed on labour mobility after enlargement, but if the number of migrants in a particular country exceeded a certain threshold proportion of the local workforce in, say, the first three years, that country could put a cap on further immigration.1 Safeguard clauses would have at least three important advantages over transitional periods. First, they would allow a response to be made to a threat that was actually emerging, and not to a hypothetical one that might never materialize. Second, they would enable integration to produce the expected benefits as migration would not be restricted throughout the EU, and therefore welfare-improving reallocation of labour could take place unhindered in regions where it would not disrupt the labour market. This would facilitate the extraction of static gains from enlargement. Third, they would allow countries such as Germany to react flexibly to any challenges posed to their welfare and pension systems by an unexpectedly large influx of labour. Finally, they would be politically acceptable as they would be compatible with the general EU principle of free labour movements. Among other suggested measures, improved wage flexibility and enhanced EU-wide labour mobility are good ideas not just because of the risk of migration from new member countries, but also for their own sake. By contrast the proposal that the CE-8 countries be required to establish a minimum social standard that would work as a disincentive for migration is problematic. First, research has not conclusively shown that the high social standards in the EU do serve as a magnet for migrants. Second, social expenditure in the CE-8 countries is already very high, or at least in proportion to incomes, and putting an additional burden on their budgets would be illadvised. Even if special financial contributions were made by the EU-15, they would be better spent on productive purposes and new job creation. The threat of illegal migration should be addressed in parallel with the liberalization of labour mobility. Strict border controls may not be effective as there are technical problems with monitoring the long eastern land borders between the EU and neighbouring countries, and there may be a lack of motivation on the part of the CE-8 countries to engage in costly border controls against migrants who are likely to go further west (a free-rider problem). Studies of the North American Free Trade Area suggest that a combination of measures should be used, including stricter border controls and workplace enforcement (Hanson et al., 2002). However actions such as amnesty should be avoided as they create a moral hazard and actually encourage illegal immigrants. Moreover special agreements on readmission should be signed with neighbouring countries to establish legal and administrative institutions and procedures to return illegal migrants to their

10 Introduction

countries of origin. Such agreements are already in force among some countries. Regional policies Income convergence between countries and regions has long been a priority in EU policy making. Convergence is usually fostered through structural and regional policies that concentrate on financial transfers to poorer regions. The extent to which such transfers add to growth or end up as funds for income support is still an open question. Theory and experience suggest that if transfers are used for income support they generally have a very limited impact on growth as they tend to weaken the incentive to search for work and exploit business opportunities. This calls for the redesigning of regional policies to ensure that the Structural and Cohesion Funds are used for growth-enhancing purposes – human capital development, innovations and R&D, institutions and essential infrastructure. The fact that the new member countries will have open access to EU funds raises a number of issues. It is uncertain whether the extent of national administrations and economic agents in these countries will be able to take full advantage the opportunities offered by the Structural and Cohesion Funds. On the one hand, in the course of participating in preaccession financial support programmes such as Phare the administrative authorities in these countries have grown accustomed to the rules governing the use of EU funds and developed some expertise in applying for and using the funds. On the other hand the actual disbursement ratio is rather low (50–70 per cent of commitments) and there are often substantial delays in using the funds. The record with implementing projects financed by other preaccession funds, such as the ISPA and SAPARD, is even less encouraging. The Structural Fund transfers to the new members after accession will be several times larger than preaccession financing, which will require a step change from past practices. It should be remembered that the disbursement ratio even for EU members with well-trained and efficient bureaucracies (for example Sweden, Austria, Finland and Ireland) is no higher than 80–85 per cent. It is extremely doubtful whether the new members will be able to achieve a similar level of disbursement in the first years after accession; a more likely outcome is an initial disbursement ratio of around 50–60 per cent. The limited absorptive capacity of the new member countries manifests itself in three distinct areas. First, there is a dearth of well-planned projects that could form part of a national development programme and be capable of meeting the stringent and substantive procedural requirements posed by the EU rules on the use of Structural Fund transfers. The lack of good eligible projects has been the most frequent cause of the low disbursement of preaccession funds. Second, the capacity of local administrations to evaluate projects and liaise between local agents and the EU authorities is limited. While some expertise in using EU funds has already been acquired it is

Michael A. Landesmann and Dariusz K. Rosati 11

mostly concentrated in central government administration; in contrast local offices are largely understaffed and their employees lack the skills (languages, familiarity with procedures) needed to process effectively and expeditously all documentation pertaining to projects. Third, the provision of EU funds is likely to be seriously hampered by the new member countries’ very limited ability to supply local funds to cofinance or prefinance projects submitted for EU support. These constraints have important implications. If no viable projects are submitted, EU funds will not be released. Similarly if insufficient domestic funds are available, even excellent projects may not be started. All in all it is probably unrealistic to expect that the new member countries will be able to take full advantage of the Structural Funds from the very beginning. It should be remembered that even the present EU countries had serious difficulty using these funds in the first years of the current financial programme (in 2000 the disbursement ratio was only around 60 per cent). If the disbursement ratio in the new member countries drops below 50 per cent in 2004 the transfers from the EU will be less than the EU-related expenditures, including the prepayment of farm subsidies and mandatory contributions to the EU budget. This is likely to result in serious budgetary imbalances in the accession countries, with potentially harmful political consequences (see the discussion of these issues in Chapter 6). One immediate risk is that if things go wrong and absorption does not exceed the 40–50 per cent threshold, the new members could become net contributors to the EU budget in 2004, and possibly also in 2005. This would certainly be a disappointing result of enlargement. However to date no policy alternative has been suggested to deal with such an outcome. Another more general conclusion is that there is an urgent need for the new members to develop their institutional absorptive capacity, and EU assistance in this area is of utmost importance. If insufficient progress is made, transfers from the Structural Funds will be phased in only gradually. Apart from budgetary complications, the much hoped for benefits from EU transfers will therefore materialize only after some time and the expected positive impact on growth will be significantly delayed, especially if some crowding out of domestic investment by EU-financed projects takes place due to lack of finance or for reasons of political convenience. There has been considerable debate on whether the Structural Funds are indeed able to accelerate convergence. One rather extreme view is that the funds should be abolished because they have been ineffective in stimulating economic growth and at the same time have provided many opportunities for corruption and mismanagement (Boldrin and Canova, 2003). One has to be sceptical about this proposal. First, the econometric tests applied to support it are problematic. If other variables, including fixed effects, are controlled for the impact of the Structural Funds becomes significant and positive. Second, it is undisputed that accelerated growth

12 Introduction

requires endowments of certain factors (human capital, infrastructure, institutions), hence the Structural Funds should be used to provide these factors when necessary. In short the call should not be for the elimination of the Structural Funds but for better allocation and improved management and monitoring. Moreover an increase in Structural Fund transfers should be considered as a means to speed up convergence and thus alleviate potential problems such as excessive migration. As argued by, among others, Erkki Liikanen and Loukas Tsoukalis in Chapter 14, regional structural policies should take greater consideration of efficiency and cost. The magnitude of the funds redistributed under regional policies should be based on the difference between the country/region’s per capita income and the EU average, and reflect the relative economic size of the country or region. While a cap should certainly be imposed on such transfers, the current limit of 4 per cent of the GDP of the receiving country may be too restrictive, given the difficulties that are likely to be encountered by the new members in getting access to these funds. Higher transfers would also help to alleviate emigration pressures from poorer regions. The enlargement will also exacerbate the more general problem of reforming the EU budget. The large transfers that will be made to the new members make the need to restrict the scope of the CAP even more pressing. Relatively more funds should be spent on development and growth-enhancing objectives while pure income transfers should be reduced. Responsibility for allocating these funds should be transferred to national governments as they are probably better able to identify local needs and determine synergies. At the same time measures should be introduced to prevent free riding and the undesirable redistribution of funds through the ‘crowding out’ of local government investment by EU funds, and to alleviate the risk of spending even more resources on social goals and income support.

The role of institutions The accumulation of physical and human capital is the most direct cause of economic growth. But there are other, more fundamental factors. As demonstrated by many writers (for example Easterly and Levine, 2001; Acemoglu et al., 2002; Rodrik et al., 2002), the most important ‘non-standard’ factors are institutions, particularly the rule of law, property rights and social capital. These writers have confirmed the earlier view (North, 1990) that stable institutions are essential to the establishment of a conducive business climate and to assuring investors that they can invest safely and enjoy returns from their investment. The role of institutions in building up a stable, well-functioning and competitive economy is addressed by several authors in this volume. In Chapter 4 György Surányi discusses the development of the banking sector in Hungary in the 1990s and argues that the early privatization of Hungarian banks,

Michael A. Landesmann and Dariusz K. Rosati 13

including sales to foreign financial institutions, was instrumental in achieving stability in the banking system in the turbulent period of transformation. George Kopits (Chapter 2) and William Branson, Jorge Braga de Macedo and Jürgen von Hagen (Chapter 1) argue that an effective macroeconomic policy may not be possible in the absence of a stable and well-developed financial sector that meets the standards of prudential regulations. The establishment of stable, high-quality institutions can only be achieved through a long-term process that involves political interaction and sensible national policies, buttressed and supplemented by appropriate EU policies. The accession process has played an important disciplinary role in shaping the institutional order in the new member countries during the last decade, but the actual functioning of the various institutions has not yet reached the required standard. The mechanism of gradual harmonization is examined in detail by Ádám Török (Chapter 5) with regard to the evolution of competition policies in Hungary. In Chapter 14 Eric Berglöf speaks of the EU accession process as an ‘outside anchor’ for institutional reforms and addresses the important question of whether this mobilizing and disciplinary effect could disappear after enlargement (as was the case in Greece in the 1980s). Similar concerns are expressed by András Inotai and Michael Landesmann in Chapter 14. Lengthy bureaucratic procedures, inefficient state and local administrations, a slow and overburdened judicial system and endemic corruption are among the most frequently cited difficulties that plague business activities. In view of the positive contribution made by a stable and business-friendly institutional environment to economic growth, support for institution building and strengthening in the new member countries should be a key factor in EU cohesion policies. One significant factor in this context is enforcement of the acquis communautaire. In its annual reports the European Commission evaluates the progress made by the new member countries in their preparations for accession. While most of the necessary legal and institutional changes have been implemented, their actual enforcement remains a concern, as discussed by Erkki Liikanen in Chapter 14 and Dariusz K. Rosati in Chapter 14. Clearly it is much easier to promulgate new laws than to ensure their proper implementation in practice. This indicates that EU policies aimed at institution building should also address institutional support, particularly with regard to the working of judicial systems, the protection of property rights, the enforcement of competition rules and the functioning of central and local government administration.

Macroeconomic policies and the accession of the new member countries to EMU The accession of the new member countries will add to the heterogeneity of the EU. These countries are not only poorer, they are also structurally different: some have large and inefficient agricultural sectors, some have

14 Introduction

relatively more trade with their eastern neighbours (the CIS countries), most suffer from high structural unemployment, and their financial sectors are still underdeveloped. Because of this it can be assumed that their macroeconomic policy priorities will differ not only from those in the EU-15 but also among themselves. This poses a triple challenge to EU-wide macroeconomic policy. First, what should be the timing and course of these countries’ accession to EMU? Second, assuming that they will adopt the euro earlier rather than later, how will the increased macroeconomic heterogeneity of the enlarged EMU area affect the design and conduct of the common monetary policy? Finally, what steps can be taken to ensure the necessary degree of fiscal discipline and coordination in a grouping of 25 countries with quite diverse macroeconomic and structural characteristics? EMU membership: some preliminary issues Before addressing the timing of the new member countries’ accession to EMU it is necessary to answer three questions. First, is it legally mandatory for these countries to join EMU? Second, will joining EMU in the foreseeable future make economic sense for them? Third, what are the likely implications of their adopting the euro for the functioning of EMU? The Maastricht Treaty makes it clear that all member countries are required to join EMU. This is apparent both from the wording of the relevant provisions, particularly the Protocol on the Transition to the Third Stage of Economic and Monetary Union,2 and from the express exclusion of the United Kingdom and Denmark from this obligation. Only these two member countries have secured the right – after long negotiations and for somewhat different reasons – to decide whether or when to move into the third stage of EMU. The EMU requirements specified in the Maastricht Treaty were extended to the new member countries at the EU summit in Copenhagen in June 1993. The economic and political conditions for accession, as formulated at that summit, included the stipulation that the candidate countries must assume the wide range of obligations arising from full membership, including membership of EMU. In contrast with Denmark and the United Kingdom, no ‘opt-out’ clause was offered to the new members. The provisions of the Maastricht Treaty imply that the new member countries will be able to join the euro zone only after they have met all the Maastricht criteria for nominal convergence. Moreover EMU membership cannot be gained in the first two years of membership.3 At the moment the countries in question are free to adopt the exchange rate regime of their choice. However in the period between gaining EU membership and joining the euro zone they will be expected to enter ERM-2. The treaty thus establishes an explicit link between the speed of the accession process for EU membership and the speed of approaching the third stage of EMU, as well as defining a specific financial convergence path for accession countries.

Michael A. Landesmann and Dariusz K. Rosati 15

However the treaty does not put this process into a specific time frame. The requirement to stay in ERM-2 for at least two years is a necessary condition for entering the euro zone; but if a country does not succeed in meeting this condition (or other criteria), entry may be postponed for years. In principle a number of factors, including speculation attacks, might occasionally push the national currency of a candidate country outside the permitted band of exchange rate fluctuations, and even deliberate policy measures aimed at delaying entry to the euro zone area cannot be excluded.4 Thus even if it is formally committed to entering the third stage of EMU, a candidate country may in fact remain outside it for years. Will early EMU entry make economic sense to the new member countries? As argued by George Kopits in Chapter 2, the answer to this question depends on whether they are part of the optimum currency area (OCA) together with the existing EMU members (assuming that the latter form an OCA – a view that is not universally accepted – see the empirical evidence presented by Calmfors et al., 1997). Analyses of trade shares and standard measures of international openness suggest that these countries are already closely integrated with the EU area (though their share of intra-industry trade with the EU is lower than within EU). Their relatively high shares of trade with the EU (ranging from 50 per cent for Latvia to 70 per cent for Poland and Hungary) suggest that their gains from joining the single currency could be substantial. On the other hand the scope for asymmetric shocks seems to be larger for them than for the EMU countries. The standard measures for correlation of the business cycle between the EU and new member countries suggest a relatively high degree of cyclical synchronization, with the correlation coefficients for the changes in GDP and the changes in industrial output ranging from 0.6 to 0.8. On the other hand Korhonen and Fidrmuc (2003) have found a lower correlation for demand and supply shocks between the new members and most EMU countries than for demand and supply shocks between EMU countries. In general the degree of integration and the exposure to asymmetric shocks varies from country to country, but on balance most of the new members seem to be no less part of a euro OCA than some of the existing members (Greece, Finland, Ireland and Spain). Accession to EMU As discussed above, the entry of the new member countries to EMU is not planned for today or tomorrow. The earliest possible date will be 2007 if the current requirement for a minimum of two years in ERM-2 is observed and if the necessary fiscal adjustment can be effected quickly enough. The need for fiscal consolidation before setting on the path to EMU is strongly emphasized by George Kopits (Chapter 2) and William Branson, Jorge Braga de Macedo and Jürgen von Hagen (Chapter 1). Kopits warns that excessive fiscal expansion, whether monetized or not, would eventually lead to

16 Introduction

currency depreciation, either through wage increases or through higher risk premia on domestic assets. This would compromise the objective of exchange rate stability. Branson et al. argue that fiscal policies should be geared to achieving internal balance by means of a multi-annual fiscal adjustment strategy (MAFAS). Such a strategy would help the new members to cope with social conflicts over income distribution and would allow them to regain effective control over the government budget. Indeed the adoption of a MAFAS implies a gradual approach to lasting fiscal consolidation. Given the political difficulty of trimming budget deficits, 2008 seems to be the earliest possible year in which the new members could enter EMU. But even if the entry to EMU takes place in 2007–8, one can expect a significant increase in intercountry heterogeneity within EMU, which poses a question about the effectiveness of monetary policy in the enlarged union. Even today the common monetary policy may not be optimal for outliers because of significant differences in macroeconomic conditions (for example in Germany versus Ireland); if the new members are admitted to EMU as early as 2007–8, these differences are likely to widen. There are several policy options that can be contemplated. First, these countries’ entry to EMU could simply be postponed until after 2010 to avoid problems with the management of monetary policy in a more heterogeneous currency area. But the rationale for this option is problematic. Intercountry differences will not disappear within three to five years – most forecasters predict that it will take two to three decades for the new members to reach 80 per cent of the average EU income level. Postponing EMU entry for so long would not make any sense as it would perpetuate the division of the EU into two distinct categories of member countries and this could have disturbing political consequences. The new members seem determined to join EMU earlier rather than later, and for some very good reasons (for a discussion, see Eichengreen and Ghironi, 2003). Moreover the degree of heterogeneity is to some extent endogenous with respect to the common currency, and the macroeconomic convergence of the new members with the core EMU countries can be expected to speed up as a result of EMU accession. A second option would be to admit the new members in 2007–8 and to adjust monetary policy accordingly in order to ensure price stability in the enlarged euro area. The restrictiveness of monetary policy might then be excessive for high-income, slow-growth outliers, although these costs could to some extent be offset by the additional economic gains stemming from the enlarged currency area. A third option assumes that after the new members enter EMU in 2007–8, monetary policy will still be geared to maintaining price stability in the current set of EMU member countries. This implies that faster-growing, catching-up new members would on balance face less stringent monetary conditions. However this ‘expansionary bias’ would not have to cause an

Michael A. Landesmann and Dariusz K. Rosati 17

overall weakening of monetary discipline, for three reasons. First, the relative economic weight of the new member countries is small, with their GDP amounting only to 5 per cent of EU-15 GDP. Second, and more importantly, real per capita convergence would take place only if there were faster productivity growth in the new member countries, which would manifest itself in higher inflation rates through the Balassa–Samuelson effect. But as this higher inflation would not be a monetary demand-driven phenomenon, it would not need to be addressed with monetary restrictions. High-income, slow-growth EMU member countries would therefore not need to suffer excessively restrictive monetary policies, or no more than would be necessary to counter the higher inflation in the new member countries. Third, the higher inflation in the latter countries would be produced entirely in nontradable sectors, and as such would not be exported to other EMU countries. In the absence of prior arrangements, after EMU enlargement monetary policy could fall victim to the conflicting interests of the individual countries represented on the governing board of the European Central Bank (ECB). The increased heterogeneity of the euro area would manifest itself in different policy preferences among the EMU members and could lead to the emergence of various coalitions within the executive board, with damaging effects on the effectiveness of monetary policy and the credibility of the ECB. The current reform of the decision-making mechanism in the ECB is only partly addressing this issue as it is concentrating on maintaining the voting balance between large and small member countries. But as policy preferences do not necessarily reflect the size of a member country, the current reform may not be sufficient to prevent all the risks that could arise from the increased heterogeneity of the euro area. Another important policy issue is related to the requirement for prospective new members of EMU to meet the nominal convergence criteria. The Maastricht criteria were formulated more than a decade ago and were meant to stimulate macroeconomic adjustment in the run-up to EMU. The criteria worked well in reducing inflation and budget deficits to manageable levels. The question is whether they can and should play the same role in the case of the new member countries. The nominal convergence criteria have been criticized on several grounds. First, the reference values for inflation and fiscal position seem to have been chosen somewhat arbitrarily. For instance why should inflation only be allowed to differ by less than 1.5 percentage points from the average inflation in three ‘best’ countries? And why is a 3 per cent budget deficit limit preferable to a 2.5 per cent or 4 per cent limit? Second, the vague and imprecise language used to define some of the criteria (especially the fiscal ones) allows for various interpretations and provides considerable scope for exceeding the formal limits. Third, the assumption that ‘one size fits all’ is seen as increasingly inadequate and problematic. For instance a rapidly growing country can easily sustain deficits that are higher than 3 per cent

18 Introduction

without breaching the public debt limit of 60 per cent in the long term. Similarly a rapidly growing country with a strong Balassa–Samuelson effect will only be able to meet the inflation criterion with a very restrictive monetary policy that will hamper economic growth. These reservations may be even more important in the current stage of EMU enlargement than they were during the earlier stage of EMU creation. The new members are considered to be fast-growth countries and as such are likely to experience a not inconsiderable Balassa–Samuelson effect. A number of studies have produced various estimates of this effect (depending on the underlying assumptions and the methodology applied) ranging from 1–2 per cent for higher-income new members to 4–5 per cent for lowerincome new members (see Kawecka-Wyrzykowska and Rosati, 2002, for a discussion). Even taking the mid-point of these estimates suggests that most of these countries will find it very difficult to meet the inflation criterion (Box I.1).

Box I.1 Imagine a fast-growth, low-income EMU candidate country where per capita GDP is 32 per cent of the EMU average. Now assume that the per capita GDP of the EMU member countries is growing at 2 per cent per annum and that the candidate country aims to speed up economic growth to achieve a per capita GDP of 75 per cent of the EMU average within 25 years (roughly one generation). Then the country’s average per capita growth rate within that period should be 5.5 per cent per annum. Assuming that productivity in non-tradables grows at the same rate in the EMU countries as in the candidate country, and ignoring possible differences in investment ratios between countries, the catching up has to come from the productivity growth differential in the production of tradables. If the share of tradables in GDP is ␣ ⫽ 35 per cent, the catching up process can be represented as: r(cc) – r(emu) ⫽ 3.5 ⫽ ␣ [␭(cc) ⫺ ␭(emu)] which implies that

␭(cc) – ␭(emu) ⫽ 10 where r(.) represent the annual per capita GDP growth rates and ␭(.) represent productivity growth rates in tradables in the candidate country (cc) and the EMU countries (emu) respectively. The obtained productivity growth differential of 10 percentage points then determines the magnitude of the Balassa–Samuelson effect (B–S), as follows: B–S ⫽ (1 – ␣) [␭(cc) ⫺ ␭(emu)] ⫽ 6.5 percentage points This shows that in order to be consistent with the catching up growth rate of 5.5 per cent per annum the inflation rate in the candidate country would have to be 6.5 percentage points higher than the average inflation rate for the EMU countries. To cut the inflation differential to the 1.5 percentage points prescribed by the Maastricht criterion would require annual GDP growth to be reduced to a mere 2.8 per cent, thus the time needed to reach 75 per cent of the EMU average would become 109 years – hardly an attractive prospect!

Michael A. Landesmann and Dariusz K. Rosati 19

The potential inconsistency between nominal convergence and real convergence has been noted by Buiter and Grafe (2003) and Eichengreen and Ghironi (2003). One possible solution would be to allow for a larger inflation differential for rapidly growing countries, provided it would result only from higher productivity differentials through the Balassa–Samuelson effect. If this proved impossible the new members would probably be prepared to make additional efforts to meet the Maastricht criteria anyway and to get into EMU even at the cost of a temporary slowdown in GDP growth. Fiscal policies in the enlarged EU At present, fiscal policies in the individual EU member countries remain firmly in the hands of national governments. But the introduction of EMU has forced member countries to place certain restrictions on their fiscal policies to ensure the necessary degree of fiscal coordination across countries and to avoid free riding. Provisions laid down in the Stability and Growth Pact (SGP) restrict national fiscal policies in two crucial respects: the fiscal position should be close to balance or in surplus in the medium term, and the size of the budget deficit should not exceed 3 per cent of GDP. Any country that breaches this limit is subject to a politically humiliating and financially costly ‘excessive deficit procedure’. The SGP has been increasingly criticized on the grounds that its provisions ignore the impact of the business cycle and do not distinguish between countries with various levels of public debt. It is also claimed that the SGP involves political procedures that do not guarantee an objective and impartial assessment. EU enlargement will probably serve to intensify this critique. The SGP is part of the acquis communautaire and its provisions are mandatory for new members. That is, both the deficit limit and the balanced budget requirement must be observed. In the event of a new member failing to reduce its budget deficit to below 3 per cent, the ‘excessive deficit procedure’ will apply, except for its sanctions part. The implications of this are painful as the country in question will not only be reprimanded by the European Council, but also payments to it from the Cohesion Fund will be suspended or cancelled. The imposition of SGP restrictions on the new member countries raises a number of policy problems. While fiscal stances vary from country to country the budget deficits of some of them exceed the reference value by a wide margin. For example Hungary, the Czech Republic and Poland reported deficits of 5–6 per cent in 2001–2. Trying to reduce the deficits to below the reference value immediately after accession may be politically difficult. It will also be economically problematic for at least three reasons. First, the debt-to-GDP ratio in all these countries is relatively low and well below the threshold value (ranging from less than 30 per cent in Estonia and the Czech Republic to 55 per cent in Hungary). If their GDP growth is higher than in

20 Introduction

the EU-15 (which seems a reasonable assumption if any catching up is indeed to take place), they can safely sustain higher deficits without accumulating excessive debt. Second, notwithstanding the need to reform their public finance sectors, and especially the expenditure side of their budgets, most of these countries will need more rather than less public investment (also because of necessary cofinancing of EU-supported projects). It will be difficult to move towards fiscal consolidation while at the same time financing new public investment. Third, the cyclical elasticity of their budget deficits is largely unknown. If it is large enough, then the medium-term balanced position would imply wide fluctuations of the deficit over the business cycle, with the 3 per cent limit being too restrictive. In such a case, the balanced budget position would be consistent with a higher deficit in recession (for example 4 per cent), or alternatively the 3 per cent limit would imply a surplus in the medium term. There are several possible ways to address these issues. One would be temporarily to waive the SGP requirements for the new member countries in 2004 (and perhaps also in 2005) and allow them to run higher deficits on the grounds that the excessive deficits were temporary and caused by exceptional circumstances. Accession to the EU and related budgetary payments could be seen as such exceptional circumstances. In 2004 these countries will not only have to contribute to the EU budget, they will also have to secure sufficient resources to cofinance EU-supported projects and prepay direct subsidies to farmers. As these are not permanent outflows but advance payments that will be refunded later, the resulting deficit can be considered temporary. Another possibility would be to grant the countries different fiscal policy standards to reflect their structural specificity, for example the threshold value for the deficit could be changed from 3 per cent to 4 per cent or 4.5 per cent for those countries that stayed outside the euro area. Clearly the latter option would require a political decision as it would constitute an explicit departure from the principle of equal treatment of EU members under the SGP. Whatever option is decided upon, any adjustment to the SGP, whether dictated by the specific circumstances of the new members or reflecting a need for wider reform, will have to preserve the delicate balance between accommodating the growing macroeconomic diversity within the enlarged EU and the principle of equal treatment, while maintaining the disciplinary powers of the SGP.

An agenda for future reform Structural reforms For some time the EU has been working on certain structural reforms to improve its functioning in the face of the new challenges. Enlargement has increased the need for some of these reforms, particularly those to do with the working of the labour markets and the structure and efficiency of the EU budget, especially the CAP.

Michael A. Landesmann and Dariusz K. Rosati 21

Labour market reform is necessary to ensure a flexible response to the opening of borders with the CE-8 countries and extracting maximum benefits from the free movement of labour. The reform should concentrate on increasing intersectoral and interregional labour mobility through a combination of job-search incentives, temporary unemployment insurance and more efficient programmes for job-search assistance, training and lifelong learning. If labour mobility in the EU continues to be considerably lower than in the United States, the European single market will remain less efficient and less competitive. As the cost of fully including new members in an unreformed CAP would probably push EU budgetary spending well beyond the limit of 1.27 per cent of GDP, during the accession negotiations the EU had to decide between two options: to reform the CAP or to pay farmers in the new member countries less than EU farmers. It opted for the latter and offered the candidates direct payments at 25 per cent of those received by EU farmers.5 Pushed against the wall in the final stage of the accession negotiations, the candidates had to accept the offer even though it clearly violated the principle of equal treatment. This, together with the promise gradually to increase the direct payments to 100 per cent of the EU level, has made all the new members strong advocates of continuing the CAP as it is. Countries such as Poland are likely to team up with France and Spain in demanding that the high level of transfers to farmers be continued. However that would be unfortunate as it would divert limited resources away from the much more justified task of promoting sustainable growth in the EU. The Eastern dimension Enlargement will shift the centre of gravity of the EU eastward. That the enlarged EU will have a common border with CIS countries, including Russia and Ukraine, has obvious implications for a wide range of community policies. Trade will expand, as will the movement of people. Relations with the Kaliningrad region after enlargement will become a special test case in the context of enhanced cooperation between the EU and the Russian Federation. It should be remembered that the new member countries have had extensive economic and political relationships with the CIS countries (indeed some were part of the Soviet Union until 1991), and the legacy of those ties will be reflected in the future formulation of economic, foreign and security policy in the EU. Given their mixed historical experiences the new members can be expected to press for a shift in EU foreign policy priorities in several directions. They are likely to favour political and economic cooperation with some eastern countries, such as Ukraine, Belarus and Moldova, but may be more cautious about political cooperation with Russia. With regard to the Balkan region, most of the new members will probably be interested in expanding their economic and political links with countries such as Yugoslavia, Macedonia, Albania and Bosnia-Herzegovina, and may hope

22 Introduction

that these countries will be granted EU membership at some later date. In any case they will have a vital interest in promoting economic and political stability to the east and south of their borders. This could result in the CIS and Balkan countries gaining more attention and support in common EU policies. But a coherent, long-term strategy for political and economic cooperation with the EU’s eastern neighbours is yet to be established. Notes 1. NUTS3 level classification could be used as this has already been used to assess the eligibility of individual regions for payments from the European Social Fund. 2. ‘The High Contracting Parties declare the irreversible character of the Community’s movement to the third stage by signing the new Treaty provisions on Economic and Monetary Union.’ 3. ‘The criterion of participation in the Exchange Rate Mechanism of the European Monetary System … shall mean that a Member State has respected the normal fluctuation margins provided for by the Exchange Rate Mechanism of the EMS without severe tensions for at least the last two years before the examination’ (Protocol on the Convergence Criteria, as mentioned in Article 109F of the Maastricht Treaty, Article 3, emphasis added). 4. Sweden, for instance, has chosen not to satisfy the exchange rate criterion and to stay out of EMU even though it does not have the formal right to do so. 5. With additional payments of an average of 20 per cent per annum coming from the structural section of the FEOGA (European Agricultural Fund for Guidance and Guarantee) in 2004–6.

References Acemoglu, D., S. Johnson and J. Robinson (2002) ‘The Reversal of Fortune: Geography and Institutions in the Making of the World Income Distribution’, Quarterly Journal of Economics, vol. 107, pp. 1231–94. Baldwin, R., J. F. Francois and R. Portes (1997) ‘The Costs and Benefits of Eastern Enlargement: The Impact on the EU and Central Europe’, Economic Policy, vol. 24, pp. 127–76. Barro, R. J. and X. Sala-i-Martin (1995) Economic Growth (New York: McGraw-Hill). Boeri, T., G. Bertola, H. Brücker, F. Corricelli, A. de la Fuente, J. J. Dolado, J. Fitzgerald, P. Garibaldi, G. Hanson, J. F. Jimeno-Serrano, R. Portes, G. Saint-Paul, A. Spillimbergo (2002) ‘Who’s Afraid of the Big Enlargement?’, CEPR Policy Paper, no. 7 (London: Centre for Economic Policy Research). Boldrin, M. and F. Canova (2003) ‘Regional Policies and EU Enlargement’, CEPR Discussion Paper, no. 3744 (London: Centre for Economic Policy Research). Breuss, F. (2001) ‘Macroeconomic Effects of EU Enlargement for Old and New Members’, WIFO Working Papers, no. 143 (Vienna: Austrian Institute of Economic Research). Brown, D., A. Deardorff, S. Djankov and R. Stern (1997) ‘An economic assessment of the integration of Czechoslovakia, Hungary and Poland into the European Union’, in S. Black (ed.), Europe’s Economy Looks East. Implications for Germany and the European Union (Cambridge: Cambridge University Press), pp. 23–60. Buiter, W. and C. Grafe (2003) ‘Patching up the Pact: some suggestions for enhancing fiscal sustainability and macroeconomic stability in an enlarged European Union’, manuscript (London: European Bank for Reconstruction and Development).

Michael A. Landesmann and Dariusz K. Rosati 23 Calmfors, L., H. Flam, N. Gottfries, J. H. Matlary, M. Jerneck, R. Lindal, Ch. Nord-Berntsson, E. Rabinowitz and A. Vredin [The Calmfors Commission] (1997) EMU – A Swedish Perspective (Dordrecht: Kluwer). Easterly, W. and R. Levine (2001) ‘It’s not factor accumulation: stylised facts and growth models’, World Bank Economic Review, vol. 15, no. 2. Eichengreen, B. and F. Ghironi (2003) ‘EMU and Enlargement’, in M. Buti and A. Sapir (eds), EMU and Economic Policy in Europe: The Challenge of the Early Years (Cheltenham: Edward Elgar). European Commission (2001) ‘The Economic Impact of Enlargement’, Enlargement Papers, no. 4 (Brussels: Directorate for Economic and Financial Affairs, European Commission). Fertig, M. (1999), ‘The economic impact of EU Enlargement: assessing the migration potential’, Discussion Paper, no. 964 (Heidelberg: Department of Economics, University of Heidelberg). Hanson, G., R. Robertson and A. Spilimbergo (2002) ‘Does border enforcement protect US workers from illegal immigration?’, Review of Economics and Statistics, vol. 84, no. 1, pp. 73–92. Kawecka-Wyrzykowska, E. and D. K. Rosati (2002) ‘The impact of EU enlargment on non-EU candidate countries. Trade and investment effects’, paper prepared for UN ECE, November. Keuschnigg, Ch. and W. Kohler (1999) ‘Eastern Enlargement of the EU: Economic Costs and Benefits for the EU Present Member States; the Case of Austria’, Study for the European Commission and the Universities of Linz and Saarland. Korhonen, I. and J. Fidrmuc (2003) ‘The euro goes East. Implications of the 2000–2002 economic slowdown for synchronisation of business cycles between the euro area and CEECs’, BOFIT Discussion Papers, 6/2003 (Helsinki: Bank of Finland). North, D. (1990) Institutions, Institutional Change and Economic Performance (Cambridge: Cambridge University Press). Rodrik, D., A. Subramanian and F. Trebbi (2002) ‘The primacy of institutions over geography and integration in economic development’, NBER Working Paper, no. 9305 (Cambridge, Mass: National Bureau of Economic Research). Sinn, H. W. et al. (2001) ‘EU-Erweiterung und Arbeitskräftemigration: Wege zu einer schrittweisen Annäherung der Arbeitsmärkte’, Ifo Beiträge zur Wirtschaftsforschung, vol. 2 (Munich). Winters, L. A. (1997) ‘What can European experience teach developing countries about integration?’, World Economy, vol. 20, pp. 889–912.

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Part I Macroeconomic Policy Issues

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1 Macroeconomic Policy and Institutions during the Transition to European Union Membership1 William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen

In this chapter a framework is developed for macroeconomic policy analysis during the transition to membership of the EU and the euro zone. The framework is applied to four accession countries in Central Europe (CE): the Czech Republic, Hungary, Poland and Slovakia. A multi-annual fiscal adjustment strategy (MAFAS) and a pre-pegging exchange rate regime (PPERR) appropriate for maintaining internal and external balance are described and evidence on budgetary procedures is presented. A comparison suggests that the four CE countries are better prepared for fiscal stabilization than Greece, Spain and Portugal were in the 1970s. Nevertheless there is still considerable room for institutional improvement. A stronger commitment to fiscal targets at the preparatory stage would improve fiscal performance in all four countries, and their transition would be more credible if they adopted some group procedures for convergence.

Introduction A common orientation for macroeconomic policy and institutions can be found in the countries of Central Europe (CE) that are set to become members of the European Union (EU) in 2004. Policy-making institutions in the Czech Republic, Hungary, Poland and Slovakia will eventually conform to those of the EU. The criteria for joining the euro zone also imply the eventual convergence of their macroeconomic performance. While the process of developing a market economy lasts several decades, and fulfilment of the criteria has not been part of the enlargement negotiations, the change in the economic regimes of the CE countries towards nominal stability is already being monitored by world financial markets. Indeed this occurs in both member and associated states. The reason for this scrutiny is that the regime change requires the countries’ medium-term strategy to be credible and their 27

28 Macroeconomic Policy and Institutions

macroeconomic framework to be understood not just internationally but also by citizens and social partners within those countries. Whether or not a reform strategy is understood at home and abroad depends on how policy-making institutions interact with the specifics of the economy and society. The absence of an efficient, equitable and simple to run tax system is seen as a major microeconomic and macroeconomic obstacle to growth, as well as to social consensus. The same is true, more broadly, of the absence of a transparent legal environment, which deters domestic and foreign investment. These examples show how institutions may determine whether popular support for reforms will be sustained during the transition or whether a ‘stop and go’ reform pattern will emerge instead, delaying adjustment and ultimately threatening national cohesion. That being said, we shall confine our analysis of institutions to budgetary procedures in four of the 10 accession countries – the Czech Republic, Hungary, Poland and Slovakia, which were the founding members of the Central European Free Trade Agreement (CEFTA). Evaluating the macroeconomic policies and performance of an economy in transition is a difficult task. In 1995 Branson and Braga de Macedo developed a framework for that purpose. Here we shall present more detailed evidence on the Czech, Polish, Hungarian and Slovak budgetary procedures and extend the framework. The first problem faced by Branson and Braga de Macedo when developing an analytical framework was that before their transition these economies had very large government and state enterprise sectors, making it difficult to distinguish monetary from fiscal policy. In their centrally planned economies there was no private sector, so there was no separate public sector and no public sector deficit or debt. Without a private sector there was no one for the public sector to have a deficit with: monetary policy was simply the provision of finance for investment in the central plan. Essentially, fiscal and monetary policy were the same thing. The four CE countries were somewhat more advanced than their neighbours in having some market institutions at the beginning of transition. As the economies moved through the transition, privatization created a private sector and the distinction between public and private sectors acquired macroeconomic significance. Fiscal policy gradually emerged as the concepts of public expenditure, tax revenues, government budget and public debt became operational. With the creation of a central bank, and the withdrawal of the central bank from automatic financing of the budget deficit, monetary policy emerged as the provision of credit to the private sector. During the transition the countries were expected to introduce marketoriented policy-making institutions in which the distinction between fiscal and monetary policy was clear, and the use of these policies in maintaining internal and external balance could be analysed in the usual fashion. Fortunately, at least for the purpose of economic analysis, these national economies, as all others, faced an external constraint throughout their

William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 29

transition. Their foreign debt could not become so large that international financial markets perceived that they could not service it. Their export earnings had to be sufficient to finance imports and debt service as the economy became increasingly marketized. Therefore the approach that Branson and Braga de Macedo took to the analysis of macroeconomic policy was first to look for signs of external balance, and then to look to internal balance as the economy was increasingly decontrolled. Signs of internal imbalance, either excessive budget deficits or unacceptably high inflation, were taken as indicators that a currently satisfactory external situation could become unsatisfactory in the future if the internal imbalance spilled over to the external sector. The authors’ second problem was how to evaluate macroeconomic policies, and possibly recommend policy changes, without a quantitative macroeconomic model. Development of a quantitative model was precluded both because the structure of the CE economies was changing rapidly, and because of the lack of sufficient data. To deal with this problem they developed as a macroeconomic framework a model of external and internal balance with high capital mobility and a fixed real exchange rate that assigned fiscal policy to internal balance and monetary policy to external balance. The focus was on the development of a multi-annual fiscal adjustment strategy (MAFAS) and a pre-pegging exchange rate regime (PPERR) as instruments for stabilization. In their approach to external balance, the CE economies could adopt a PPERR that would essentially entail no active nominal devaluation aimed at real devaluation as the country converged towards EU membership. In their approach to internal balance, the CE countries could adopt a MAFAS. Both of these policy paths could bring the economies to the point of accession to the EU along as smooth a convergence path as possible. In general, PPERR and MAFAS would be credible policies to stabilize the economy as it entered the world market. The PPERR would avoid the ‘inconsistent trio’ of fixed exchange rate, free capital movements and independent monetary policy by freeing monetary policy to be targeted on external balance, represented by a suitable reserve position. The MAFAS would then set fiscal policy to maintain internal balance, as represented by a low rate of inflation. The arithmetic of debt sustainability could be used to determine the appropriate primary deficit that was consistent with a non-growing ratio of debt to output. Thus the fiscal adjustment could be consistent with low inflation and a non-growing debt ratio. A good institutional environment is an important prerequisite for a successful transition to EU membership. Indicators of regime change featuring the development of market institutions (especially those made available by the European Bank for Reconstruction and Development) suggest that the four CE countries already rank very highly for most indicators (for example small-scale privatization, trade and foreign exchange regime, enterprise

30 Macroeconomic Policy and Institutions

restructuring, price liberalization, banking reform, large-scale privatization, competition policy, capital markets and legal reform). The variation over time and across countries is of course much greater in countries in the early and intermediate stages of transition. The credibility of transition also requires policy-making institutions in the monetary and fiscal fields, which did not exist under central planning, but the institutional requirements are more exacting and more country-specific than the independence of the central bank in matters of monetary policy that was envisioned in the EU Treaty. Certainly, monetary financing of budget deficits was curtailed during stabilization in former Czechoslovakia, and continues to be forbidden in the Czech Republic and Slovakia, but the situation is less promising in Hungary and Poland. In the following section we shall address the difficulties of emerging fiscal and monetary policy by discussing the institutional arrangements for credible fiscal policymaking. We shall also evaluate the progress of the four CE countries towards attaining an institutional framework that is conducive to stable public finances. In the subsequent section we shall deal with the absence of quantitative models by presenting a framework for evaluating a macroeconomic transition path and applying it to the four CE countries. Both sections draw on our previous work.

Budgeting and a credible MAFAS The role of the budget process in economic transition A basic problem in all transitional economies is to achieve effective control over the government budget. Since the transition is from a state of central planning and strong involvement of the government in the production sector, achieving control over the budget is connected with the problem of reducing and restructuring government expenditures and strengthening the government’s system of tax revenues. This means that fiscal reform necessarily involves major distributional conflicts. Economic analyses (for example Alesina and Drazen, 1991; Velasco, 1999) predict that distributional conflicts jeopardize reform programmes. The fight between differing societal groups over the allocation of the reform’s costs and benefits leads to postponement and to solutions of reciprocity, that is political outcomes that hold some good for everyone but an inefficient outcome for society. Institutional structures can help avoid such inefficiencies. Of course institutions do not make distributional conflicts disappear, but by defining the rules of the game they can structure the ways in which opposing parties can present and defend their claims. Institutional rules divide decision-making processes into individual steps and determine which steps are taken when, they assign roles and responsibilities to the various actors, and by regulating the flow of information they distribute strategic influence and create or destroy opportunities for collusion. A basic claim of

William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 31

political economy is that institutional rules have systematic effects on the outcome of the decision-making processes they govern. The budget process is the set of institutional rules that are relevant in the context of budgetary policies, and therefore in the context of fiscal reform. Formally the budget is a list of revenues and expenses conveying what the government expects and is authorized to do during a certain period of time. The budget process, in the broadest sense, is a system of rules, both formal and informal, governing the decision-making process that leads to the formulation of a budget by the executive, its passage through the legislature and its implementation. Political economy views the budget process as a mechanism through which political interest groups ‘bargain over conflicting goals, make side-payments, and try to motivate one another to accomplish their objectives’ (Wildavsky, 1975, p. 4). Constitutional theory holds that the budget process should be the principal and effective locus of conflict resolution between competing claims on public resources, to assure the stability, consistency, and efficiency of the government’s financial policy. Informal decision making and agreements outside the budget process, ‘nondecisions’ (that is, the lack of nodes of deliberate decisions in the process) and the use of off-budget funds are all sources of constitutional failure of the budget process. They promote irresponsibility and obscurity of government financial policies (von Hagen and Harden, 1994). The importance of individual elements of the budget process, such as veto powers or committee structures, for fiscal performance has long been studied empirically in the context of US state governments, but recently an emerging body of literature has considered the impact of the budget process on the fiscal performance of national governments on an international scale. In contrast to the American literature, this new approach is based on comprehensive characterizations of the budget process, summarized in numerical indices that describe the quality of a process. Thus von Hagen (1992) and von Hagen and Harden (1994, 1996) show that the stark differences in fiscal performance among the EU governments can be explained to a large extent by differences in budgetary institutions. They identify decentralization of the budget process – that is, the degree to which geographical, sectoral or other special interests dominate the common interest of the government in budgetary decisions – as the main cause of weak fiscal discipline. Specifically they show that countries with a low degree of centralization of the budget process systematically have higher ratios of public spending, deficits and debts to GDP than countries with large degrees of centralization. Similarly Alesina et al. (1996) show that Latin American countries with a high degree of centralization of the budget process have lower deficits and debts. Their results also suggest that Latin American countries with a centralized budget process are able to achieve a greater macroeconomic stabilization and are less prone to credit rationing. All this evidence suggests that

32 Macroeconomic Policy and Institutions

an appropriate budget process is an important prerequisite of a successful fiscal regime, and that reform of the budget process can be an important part of a fiscal reform aimed at fiscal stabilization (see also Poterba and von Hagen, 1999). Political economy considerations A general characteristic of modern public finances is that government activities, including tax benefits, tend to be targeted at specific groups while being paid for by the general taxpayer. The incongruence between those who benefit and those who pay has important implications. Policy makers representing spending agencies or groups that benefit from particular public activities take into account the full benefit from expanding the programmes they are concerned with, but recognize only that part of the costs that falls on their constituencies. As a result policy makers systematically overestimate the net marginal benefit of increased public spending, and therefore use their political influence to increase spending beyond the level that would equate social marginal costs and benefits. For example a member of parliament representing a local electoral district will appreciate the full value of road improvements for the local economy. But since the district pays only a small portion of the central government’s tax revenues, the MP will ask for more road improvements when the central government pays for them than when they have to be paid for by local taxes. As all policy makers have reasons to behave in the same way, the result is excessive spending. Even if current spending is divided efficiently between current and future taxes, it also leads to excessive deficits and debts. This is the ‘common pool problem’ of government budgeting. Poterba and von Hagen (1999) show that the common pool problem generates both excessive spending and excessive deficits and debt. Obviously it is a result of a coordination failure among the participants of budgetary decisions: as in other common pool problems, the issue is that the individual decision maker does not recognize the externality that his or her optimal decision exerts on the others. Specifically, an individual decision maker bidding for more public money does not take into account the resulting increase in the burden falling on (current and future) taxpayers who are not members of his or her constituency. The basic claim of the political economy of budgeting is that this coordination failure can be overcome by an appropriately designed budget process. To achieve this, the budget process must promote decision making with a view towards the common interest of the government rather than the individual interests of politicians who represent interest groups. Thus a budget process with a high degree of centralization helps to internalize the relevant externalities and reduces the spending and deficit biases that result from the common pool problem. As with other common-pool problems, leadership and bargaining are the principal mechanisms to employ for this purpose.

William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 33

The budget processes of EU states can generally be divided into four main steps: a preparatory stage within the executive, a legislative stage in parliament, an implementation stage, again within the executive, and an ex post control stage involving courts of auditors or similar institutions. Here we are mainly concerned with the first three stages. For each one of these, institutional mechanisms can be identified that mitigate the common pool problem. During the preparatory stage the budget process can be interpreted as a game between the various ministers forming the government. Ministers who head spending departments represent special interests within the executive. In contrast the prime minister and the finance minister can be assumed to put more emphasis on the collective interest of the government as a group. There are two principal mechanisms to achieve this. One is collective bargaining among the spending ministers at the outset of the process to set the main parameters of the budget (that is, its total size, departmental allocations and the size of the deficit). The other is to give the finance minister and the prime minister a role of strategic dominance over the spending ministers. Since the prime minister and the finance minister pursue the collective interest of the group rather than individual or sectoral interests, vesting them with special powers reduces the influence of special interests in budgetary decisions. Hallerberg and von Hagen (1997) argue that the choice between these two approaches is ultimately a function of the structure of government: multiparty coalition governments will find it easier to adopt a bargaining approach than to vest the finance minister – who is necessarily a member of one of the coalition parties – with special powers, since this would raise a legitimate fear that the finance minister would use her or his powers to favour the members of her or his own party. To increase the stability of the bargaining approach, coalition governments often write their fiscal strategy into the coalition agreement to protect it against reneging. In contrast single-party governments tend to prefer the strategic dominance approach because it is more flexible than a negotiated coalition agreement. This pattern of choices can be observed among EU governments. At the parliamentary stage the degree of centralization depends largely on the agenda-setting power of the executive over the legislature. Agendasetting power is stronger in unicameral systems, where the executive faces only one opponent, than in bicameral systems. In bicameral systems the executive’s agenda-setting power is strengthened if the budgetary powers of the upper house are limited, such as in France, Germany and the United States. Furthermore, agenda-setting power depends on the scope of amendments that parliament can make to the government’s budget proposal, and on the government’s ability to impose a voting procedure on parliament, such as a vote of confidence or the possibility to force parliament to vote over large sections of the budget simultaneously. At the implementation stage the critical variable is the degree to which the budget law effectively binds government actions. The more scope there

34 Macroeconomic Policy and Institutions

is for deviations from the budget Act, and the more frequent supplementary budgets are, the less binding is the budget Act. Furthermore strengthening the finance minister’s control over budget implementation, for example by subjecting spending departments to quarterly cash limits, limits the scope of strategic behaviour during the implementation. A final dimension concerns the informativeness of the budget documents. The less informative they are the more the government can hide its true intentions from the scrutiny of parliamentary committees and the ex post control organs, leading to greater scope for deviations from the Budget Act. Von Hagen and Harden (1996) have constructed indices that characterize the budget processes of European governments in these dimensions. A large value on their index of centralization indicates a high degree of centralization. According to the political economy of budgeting, this should be paired with smaller deficits than a small value of the index and the data confirm that prediction. As an appropriately designed government budget process is an important element of a fiscal strategy aimed at fiscal stabilization, the budget processes in the four CE countries are crucial to their macroeconomic reform strategies. We shall consider this in the following subsection. Budget processes in the four CE countries Obviously the budgetary institutions in the CE countries are still very young. Even where all the necessary laws exist, they have been in operation only for a short time so a common understanding of the rules for all participants in the process, which is often more important in practice than is the letter of the law, is still only emerging. Nevertheless a first assessment of the young institutions is possible. For this purpose our research is based on a questionnaire answered by local experts from the government and the central bank. The answers of the respondents are used to characterize the budget processes using a list of items from von Hagen (1992). These items are listed in Table 1.1. They are grouped in four dimensions: the degrees of centralization of each of the three stages of the budget process, and the informativeness of the budget. Budget preparation in the four countries is the responsibility of the executive branch of government. It starts with the formulation of budgetary targets for total spending and revenues. These targets are proposed by the prime minister or the finance minister and adopted by the cabinet. In Poland and the Czech Republic, other members of the cabinet can make counterproposals. In Hungary and Slovakia, fiscal targets are part of the government’s coalition agreement. It is only in Slovakia that they are not fully derived from general macroeconomic forecasts. Budget negotiations are conducted bilaterally between the finance minister and the spending ministers; any remaining conflicts from these bilateral negotiations are resolved in cabinet meetings (Czech Republic, Poland and Hungary) or by senior cabinet committees (Slovakia and Hungary). The latter tends to provide a greater check on reciprocity than the former, and hence promotes fiscal discipline.

William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 35 Table 1.1 Dimensions of budget characterizations Preparatory stage

Parliamentary stage

Implementation stage

Informativeness

Existence of numerical constraints for budget Commitment power of numerical constraints Structure of budget negotiations Agenda-setting power of finance minister Procedure for conflict resolution

Formal limits on amendments

Blocking power of finance minister

Scope of off-budget funds

Amendments required to leave deficit unchanged Budgetary powers of upper house

Existence of cash limits on departments

Separation of budget documents

Requirement of disbursement approval Carryover of funds to next year

Transparency of budget documents

Scope of budgetary transfers

Government loans reported

Government power to choose voting procedure Government power to call vote of confidence. Sequence of votes

Link to national accounts

Difficulty obtaining supplementary budget

Source: von Hagen (1992).

Of the four countries, only Poland has a bicameral parliament. The upper house examines and amends the budget under the same rules as the lower house. However its budget can be overruled by an absolute majority vote in the lower house. In the Czech Republic parliamentary amendments are formally restricted in that they cannot change the overall balance of the budget. In Slovakia an amendment requires the consent of the executive. In Poland and Slovakia the government’s position is strengthened by the rule that its proposal will be implemented if parliament does not pass a budget bill on time. In Poland the president can dissolve parliament if a budget has not been passed on time, while in the other two countries the previous budget will be prorated into the next year. The Polish parliament holds an initial vote on the government’s proposal, and if the proposal is rejected the government is forced to resign. There are strong similarities between the four countries’ implementation stages. Spending departments are required to seek approval before they can spend funds and are subject to cash limits to control the flow of funds. In Slovakia, Poland and Hungary the finance minister can block expenditures during implementation. Budgetary transfers are possible within chapters of the budget; transfers between chapters can be authorized by the finance

36 Macroeconomic Policy and Institutions

ministers in Hungary and Slovakia. The Czech finance minister can authorize substantive changes in the budget in exceptional cases without legislative approval. Carrying over funds into the next fiscal year requires legislative approval in the Czech Republic and Hungary. In Slovakia a limited portion of the budget can be carried over without explicit approval, while in Poland investment expenditures can be carried over with no limits, reserves cannot be carried over at all and the carry-over of other funds requires authorization by the cabinet. National budgets are presented in a unified document, except in Hungary. With the exception of Poland, the budget document provides a breakdown by functional classifications, administrative responsibility, sources of revenue and a classification of capital and current expenditures. A link to national accounting is provided in Poland and Slovakia. Social security and other transfer programmes are not included in the government budget. To translate these qualitative characterizations into a numerical scale we follow the methodology of von Hagen (1992). A score ranging from zero to four is given to each item. The scores are then normalized, such that the maximum score in each dimension is 16. The overall index is the harmonic mean of these four subindices. Table 1.2 reports the scores of the four countries according to each item and the overall index. On the overall index, the differences among the four countries are small compared with the differences among the EU countries, where the index ranges from 5 to 15. But the differences among them in the case of individual items are interesting. Centralization at the preparatory stage is weak in the Czech Republic and Poland compared with Hungary and Slovakia. This is mainly due to the greater scope for compromise among the cabinet members (a greater scope for reciprocity) in the former countries and the link between fiscal targets and coalition agreements in the latter two. Centralization at the legislative stage is stronger in the Czech Republic – the only country with formal limits on amendments – and Hungary, where the government seems to have more control over voting procedures relating to

Table 1.2 Index of centralization for four budget processes

Centralization at executive stage Centralization at parliamentary stage Centralization at implementation stage Informativeness Overall index

Czech Republic

Poland

Slovak Republic

Hungary

6.7

7.3

10.7

11.3

8.0

5.0

5.5

7.0

11.2 10.4 8.9

10.0 12.0 8.1

11.0 14.4 9.8

11.9 7.2 9.1

William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 37

the budget. The relatively small importance of off-budget funds contributes to Slovakia’s high ranking for informativeness; in Hungary informativeness is lower, partly because of the importance of the off-budget activities of the government. The purpose of these indices is to facilitate cross-country comparisons of institutional environments and to derive predictions about the relative fiscal performance of the countries considered. Two strong caveats apply to the latter function. First, all four countries are still in the process of transition and started this process from different fiscal positions. This is particularly true for the Czech Republic and Slovakia. The splitting of Czechoslovakia in 1993 had very different budgetary implications for the two countries, with windfall gains for the Czech government and windfall losses for the Slovak government. This makes it difficult to compare their fiscal performances in terms of deficit and spending ratios. Second, the institutions characterized by our indices are still young. In contrast to the EU and Latin American experiences described in other studies, we are unable to rely on established practices. The relatively strong design of the budget process in Slovakia, for example, may be a reflection of the fiscal crisis it experienced after the split, while the relatively weak design of the Czech process may reflect a degree of complacency on the part of the government after the relatively comfortable fiscal outcomes in 1993 and 1994. The indicators of fiscal outcomes in Table 1.3 show falling ratios of central government expenditure to GDP, with a reversal in the Czech Republic in 1998, in Poland in 2000 and in Slovakia and Hungary in 2001. Budget deficits have also tended to deteriorate in recent years. While the stronger Table 1.3 Fiscal outcomes (percentage of GDP)1 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 General government deficit Czech Republic2 ⫺0.2 ⫺0.8 ⫺0.3 Poland3 2.8 2.7 2.4 Slovak Republic2 5.8 4.5 0.9 Hungary4 4.2 8.4 6.7 Central government spending Czech Republic 35.0 32.1 Poland 32.3 32.7 Slovak Republic 47.0 33.3 Hungary 35.0 34.7

31.3 29.6 30.1 30.8

0.7 2.4 1.4 3.0

1.2 1.2 4.3 4.8

1.5 2.4 4.4 6.3

0.6 2.0 3.5 3.4

2.4 2.2 3.3 3.4

3.1 4.3 4.5 2.9

2.0 5.1 4.9 9.7

30.9 28.1 30.5 32.0

31.2 26.6 30.7 31.6

30.8 25.2 25.4 31.5

31.4 22.5 27.7 31.3

31.9 22.1 26.5 30.8

32.2 23.1 25.2 30.2

33.4 23.8 25.8 36.1

Notes 1. Minus sign indicates a surplus. 2. Central government deficit in 2001–2. 3. Central government deficit. 4. From 1994, excludes revenues from privatization. Source: WIIW Database.

38 Macroeconomic Policy and Institutions

design of the budget processes in those two countries may have aided fiscal consolidation, the Hungarian situation deteriorated in 2002, as noted by Braga de Macedo and Reisen (2003). International comparisons Finally, it is interesting to use the institutional indices for a comparison between the four countries and the current members of the EU. Poland comes closest to Spain (index ⫽ 7.8) and the Czech Republic falls between Spain and Portugal (index ⫽ 8.1). Austria (index ⫽ 10.2) is closer to Slovakia and Hungary. Greece has an index value of 5.4. Centralization at the preparatory stage is comparable to the Netherlands (9.8) and Portugal (9.8), stronger than in Italy (5.1) and Spain (5.3), but much weaker than in Denmark (12.2) and Austria (13.2). Centralization at the legislative stage is comparable to Denmark (8.0) in the Czech case, but due to the lack of amendment controls it is only comparable to Italy (5.0) and Ireland (5.0) in the other cases. In contrast centralization at the implementation stage is relatively high, comparable to Austria (11.4) and Denmark (9.6). Similarly the four countries score relatively well with regard to the informativeness of the budget, on which point the Netherlands (14.4) and Denmark (10.6) have comparable index values. Improvement in procedures from the viewpoint of future taxpayers have been slow, partly because budgetary institutions in the EU states have remained virtually unchanged for decades. In the early 1980s improvements did occur in Denmark, largely for domestic reasons. Considering the recent experience of the Southern European countries with multiparty democracy, the transition to a more market-oriented regime and fiscal outcomes is particularly interesting for the CE countries as institutional change and macroeconomic performance interact. Greece, Spain and Portugal all experienced rapidly rising government expenditures and deficits after their liberalization, as described by Bliss and Braga de Macedo (1990). Implementation of a convergence programme is easier if some group procedures can be adopted. The difficulties with implementing the Stability and Growth Pact in the euro zone and the interference with other areas of institutional reform suggest that adaptation to the current accession countries will be slow (Braga de Macedo and Reisen, 2003).

The macro evaluation framework Policy assignment A basic problem with all transition economies is analysing their macroeconomic policies without a quantitative model. This problem has come up in the course of evaluating the World Bank structural adjustment programmes (Branson et al., 1996). A framework that combines a model of policy assignment and debt sustainability criteria has been developed to deal with the problem. A version of this framework, adapted for the particular

William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 39

circumstances of the CE countries, seems useful for analysing their macro policies with reference to a convergence programme that would encompass a PPERR, a MAFAS and a catalogue of structural measures designed to remove macroeconomic and microeconomic obstacles to growth. The convergence programme presumably has realistic objectives for internal balance (represented by GDP growth and inflation), external balance (represented by foreign exchange reserves) and the current account (and thereby growth of debt). The programme sets instruments for fiscal policy, monetary policy and the exchange rate that are expected simultaneously to bring the economy at least close to the objectives. No issue of policy assignment arises at this stage. However, during the course of the programme it is almost certain that some unpredictable disturbance will appear, and policy will have to be adjusted. But if time and information are in short supply, it is essential to know in advance which instrument should take the lead in adjustment, depending on which target variable has gone off course. The reason for this is that some pairings of instruments to targets will lead to convergence towards the joint objectives, but other pairings will lead away. The first pairings are stable policy assignments; the second are unstable. The basis for a stable policy assignment is the principle of effective market classification, which says that each instrument should be assigned to the target variable that is relatively most sensitive to that instrument (Mundell, 1962). Essentially this is the application of the principle of comparative advantage to policy choice. Mundell has analysed the problem of assignment when there are two targets and two instruments. The government budget surplus represents fiscal policy and the interest rate represents monetary policy. These are used as instruments to reach internal and external balance. The targets are measured by non-inflationary aggregate demand and balance of payments equilibrium respectively. Stability is ensured by assigning fiscal policy to internal balance and monetary policy to external balance. Mundell also shows that the opposite assignment is unstable. An example of an unstable assignment that is relevant to rapid reformers in Central Europe is a monetary policy reaction to the investment boom that would follow if the transition to EU membership were perceived to be successful. Figure 1.1 illustrates the situation. The economy is represented at point T0 after the transition begins and before an investment boom, which would shift both equilibrium curves outwards (or upwards – it is the same thing as both are downward sloping). The budget or monetary policy would have to be tightened for both the internal and the external balance. The target for policy would move to point T1 in the figure. An initial fiscal policy reaction would take the economy to point A, close to T1, requiring small policy adjustments to get right on target. If fiscal policy was not adjusted sufficiently, monetary policy would be left to hold down aggregate demand. An initial monetary policy reaction would take the economy towards a point such as X, with internal balance but a balance of

40 Macroeconomic Policy and Institutions

X I

Interest rate

E T1 T0

A

I

E

Budget surplus Figure 1.1 Policy reaction to an investment boom Source: Branson and Braga de Macedo (1995).

payments surplus. The unstable assignment would move the economy away from the joint target. Once again the stable assignment would be fiscal policy to maintain internal balance and monetary policy to maintain external balance. Application to the CE countries In the application to the CE countries, our macro evaluation framework extends the assignment model to three targets and three instruments. It uses the principle of effective market classification to assign fiscal policy to internal balance, the real exchange rate to the current account, and the interest rate to external balance in terms of foreign exchange reserves. We generally assume that an unacceptably high level of aggregate demand (or a high rate of inflation) indicates the need for a reduction of the primary (or non-interest) budget deficit or an increase in the surplus. This can be interpreted either as reducing inflation by reducing aggregate demand, or as reducing the need for inflation-tax financing of the deficit. As in the two-bytwo example just described, we assume that the level of aggregate demand, A, depends on the primary budget deficit, p, and the real interest rate, r: A ⫽ A(p, r); Ap ⬎ 0; Ar ⬍ 0

(1.1)

The corresponding adjustment equation for the primary deficit can be written as dp ⫽ ⫺␦ [A(p, r) ⫺ A*]

(1.2)

William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 41

Here the primary deficit is assumed to adjust to the difference between aggregate demand and its target value, A*. There are two objectives for external balance: appropriate levels for the current account balance and foreign exchange reserves. The path of the real exchange rate, e, is tied to the current account objective, which is a suitable level of the primary current account balance, C. Then the domestic rate of inflation gives the path of the nominal exchange rate that is consistent with that path of the real rate which attains the current account objective. The current account adjustment equation is given by de ⫽ ⫺␭[C (e, Z) ⫺ C*]; Ce ⬎ 0

(1.3)

Here C* is the target for the primary current account balance and Z represents other variables affecting the primary current account. Most countries have some degree of international capital mobility, so if their real interest rates drop too far below the international rates there will be a capital outflow and loss of reserves. This implies that maintenance of external balance in terms of the level of foreign exchange reserves requires real interest rates to be kept high enough relative to international rates for the relevant investors to be willing to keep their deposits and other investments in the country. This relationship is expressed by the capital mobility term K in the following equation: dF ⫺ dR ⫽ K[r ⫺ r* ⫺ de ⫺ rp(p)]; K⬘ ⬎ 0; rp⬘ ⬎ 0

(1.4)

where dF is the total capital account, the change in national net foreign assets, dR is the change in net foreign exchange reserves and K is the net private capital inflow. F, R and K are all measured in foreign exchange. Following Branson and Jaffee (1991), K is a function of the interest differential adjusted for expected real depreciation and a risk premium, where r is the domestic real interest rate, r* is the international real interest rate, de is now the expected rate of depreciation of the real exchange rate, and rp is a risk premium that embodies the market’s estimate of the risk of holding local currency assets, the monopoly power of local financial intermediaries and other aspects of financial structure capital markets. It includes departures from uncovered interest parity and changes in the real exchange rate rather than the decomposition between political and currency risk used, for example, by Frankel and MacArthur (1988). The risk premium is assumed to be an increasing function of the primary budget deficit, p. The degree of capital mobility is expressed in the size of the positive derivative of the capital mobility term, K⬘. The corresponding adjustment equation for the real interest rate is given by dr ⫽ ⫺␤[K ⫺ K*]

(1.5) *

where K is specified as in Equation 1.4 and K is the target for the private capital account. Given dF, this implies the target for reserve movements.

42 Macroeconomic Policy and Institutions

The three adjustment equations can be linearized around the equilibrium values of e, p and r (denoted respectively by ˜e, ˜p, ˜r ) and presented in matrix form:

冢冣冤

冥冢 冣

0 de ⫺␭ce 0 ⫺␦Ar ⫺␦Ap dp ⫽ 0 ⫺␤K⬘rp⬘ ⫺␤K⬘ 0 dr

e p r

⫺˜e ⫺p˜ ⫺˜r

(1.6)

This system is recursive for simplicity. It would be easy to include p or r in the Z vector, which affects the primary current account in Equation 1.3. Given that the matrix is bloc-diagonal, the stability conditions are a negative trace and a positive determinant of the two-by-two system in the lower block of the matrix in Equation 1.6. This is the system behind the example in Figure 1.1. It is clear from our sign assumptions that the trace of the matrix is negative and the sign of the determinant of the two-by-two system is positive. Returning to Figure 1.1, this can be seen as implying a real exchange rate that keeps the current account at its desired level. To the extent that the investment boom falls exclusively on domestic goods, the equilibrium real exchange rate would not change in the adjustment process. In general, however, the real exchange rate will have to change. If Equation 1.3 is violated and the required change in e does not happen, the two-by-two policy assignment can no longer ensure stable adjustment to the new three-by-three equilibrium. Domestic and foreign debt sustainability The policy assignments discussed above include a target value for the current account and a policy setting for the primary budget deficit. These are respectively the rates of change of the country’s foreign debt and the government’s public debt, introducing an intertemporal dimension into the discussion. The intertemporal consistency of the application of the macro framework can be checked by looking at the arithmetic of foreign or public debt sustainability (Cohen, 1985). The country’s budget constraint in real terms can be written as a formula for the growth of the ratio of foreign debt to exports: df ⫽ (r* ⫺ n*)f ⫹ c(e)

(1.7)

where f is the ratio of foreign debt to exports, df is its arithmetic (not percentage) annual increase, r* is the international real interest rate from Equation 1.4, n* is the growth rate of exports and c is the primary current account deficit as a fraction of exports (with c⬘ being positive). In the case of public debt, the government’s budget constraint in real terms is db ⫽ (r ⫺ n)b ⫹ p ⫺ s

(1.8)

William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 43

where b is the ratio of public debt to GDP, db is its arithmetic annual increase, r is the real interest rate, n is the growth rate of real GDP, p is now the primary budget deficit as a fraction of GDP and s is the ratio of seigniorage to GDP. Seigniorage here includes both inflation tax and real growth in the demand for base money as the economy grows. The seigniorage term in the debt dynamics Equation (1.8) is s ⫽ (dq ⫹ n)/v

(1.9)

where dq is the inflation rate and v is the velocity of base money. The intertemporal model gives the equilibrium values for e, p and r in the assignment model presented in Equation 1.6. To solve the intertemporal model we first use Equation 1.9 to determine s. Then Equation 1.7 is one equation in the policy variables r and p, given the objective of db ⫽ 0. Equation 1.4 can be solved for the tradeoff between the two policy variables r and p, given dF ⫺ dR. Equation 1.7 can be solved for the value of the real exchange rate, e, which creates a primary current account surplus that sets df ⫽ 0, recursive to the first two equations. In general the current values of the variables on the right-hand side of Equations 1.7 and 1.8 are known, so they can be used to calculate the paths of the debt ratios if it is assumed that the paths of these variables remain unchanged. However these variables are all endogenous and their paths will change over time. In the absence of a quantitative model it is difficult to predict how their paths will change, so we need to use the assignment model for policy to proceed incrementally. The directions for policy change indicated by the debt dynamics approach are the same as those indicated by the policy assignment model. If inflation threatens internal balance – reduce the primary budget deficit. If the current account deficit is too large – devalue in real terms. If foreign exchange reserves are too low or falling too fast – tighten monetary policy; that is, shift from money financing towards debt financing of the existing budget deficit. These three relationships give the direction of policy actions and the expected outcomes. A policy matrix applied to the CE countries The CE countries offer especially interesting conditions for application of the macroeconomic framework. Their commitment to eventual adherence to the EU gives them clear terminal conditions, including either a fixed nominal exchange rate or joining the single currency. Thus while an early devaluation to establish external balance may be necessary, at some point along the path they will adopt a PPERR, limiting the movement of the exchange rate – what the EU Treaty calls observation of ‘normal fluctuation margins’. The introduction of a PPERR will also require a successful move to full currency convertibility. As the CE countries are developing countries with changing structures, any MAFAS and PPERR must be flexible enough to accommodate structural

44 Macroeconomic Policy and Institutions

change. In a sense the countries are also competing with each other not to fall behind in the accession process. So getting to the point where a MAFAS and PPERR can be credibly adopted has some urgency. Applying the framework to the CE countries, the movements of target variables and instruments can be seen to correspond to those expected since the beginning of the transition. This could be taken as a test of how far they have progressed in the transition. For example Branson and Braga de Macedo (1995) show that the correspondence between movements in net exports of goods and non-factor services and the real effective exchange rate is reasonable in all cases, and that between the inflation rate and the budget deficit is not bad. We now want to gain some idea of which countries are close to the point at which they can adopt a MAFAS and PPERR, and which countries may require front-loaded structural adjustment – in the form of deficit-reduction procedures or real devaluation – before adopting a MAFAS and PPERR. We first focus on external balance. The countries still have to privatize a substantial part of their public sectors, the degree of public debt is unclear as data are not fully available, and coverage of the public sector deficit is uncertain. In addition, in some cases there is still a degree of price control, which makes the existence of internal balance unclear. On the other hand the existence of external balance and external constraints are clear. Thus we first ask if the economy is in external balance, both in terms of the current stock of foreign debt and in terms of the current flow in the current account deficit. Then we ask if the fiscal position is consistent with internal balance, taking a large fiscal deficit as an indicator that the current external balance may be threatened in the future (see the discussion in the second section of this chapter). For external balance we check whether the net exports of goods and nonfactor services, as the flow measure, correspond to the real effective exchange rate as expected. In particular, does the trend in net exports suggest the need for a real devaluation prior to adopting a PPERR? When assessing the trend in net exports we also look at the dynamics of foreign debt. Up to 1994 Hungary had the most rapid increase in the ratio, with foreign debt rising by almost 50 per cent of export revenue in a year. Poland also had a rising ratio. Slovakia’s was near zero and the Czech ratio was falling. If the current ratio of foreign debt to exports is not increasing, then a country is likely to be able to sustain its debt path in the absence of structural change without negative consequences for the current account. As a measure of internal balance we look to the inflation rate, with the budget deficit as the corresponding policy instrument. The aggregate budget deficit is a necessary but not sufficient indicator for internal balance, for institutional, measurement and structural reasons. Fiscal consolidation will involve major structural changes to the budget. Apart from further improvements in the tax system, measures are likely to be taken on the expenditure side. An example is the very high level of publicly

William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 45

provided pensions, with liberal provisions for retirement. In several of the CE countries, public pension payments amount to well over 10 per cent of GDP. If we use a discount rate of 10 per cent to capitalize this flow, pension debt is 100 per cent of GDP. Thus something structural is likely to be done about pensions, as well as many other fiscal issues. Fiscal consolidation may require some form of social contract to be effective, and it will change the future fiscal position. In a situation in which a public–private distinction is still emerging, there are conceptual and practical problems with measuring the public deficit and, even worse, the public debt. These reflect the initial absence of a private sector, as discussed in the introduction to this chapter. There is a substantial overlap between monetary and fiscal policy as a considerable proportion of credit creation finances public sector activity early in the transition. Thus in the early stages net domestic credit creation may be the best measure of fiscal policy, rather than the budget deficit. Unfortunately data on credit creation are only available sometime after the beginning of the transition for the CE countries, so it is difficult to make comparisons from the start of the transition. As the private sector and central bank develop, the focus shifts to the budget deficit as the measure of fiscal policy. Branson and Braga de Macedo (1995) have tracked both credit creation and the budget deficit as fiscal measures. It would be good to have a measure of the weight of the private sector in the economy as a way of weighting the two measures. Normally when analysing macroeconomic policy we use a version of Equation 1.8 to study the sustainability of public debt. However the lack of a clear distinction between the private and public sectors in the CE countries and the lack of data make this impossible. The existence of substantial arrears among public enterprises, the financial system and the government, with gross debt probably much greater than net debt, would make the assignment of debt to sectors conceptually difficult even if we had the necessary data. The existence of unmeasured future claims on the government, such as the pension problem mentioned earlier, add to the conceptual difficulty. Perhaps the CE governments will have an opportunity to introduce a system of generational accounting as their budget processes develop (see Auerbach et al., 1999). The macro framework applied to the CE countries is summarized in the policy matrix of Figure 1.2. At the top we ask whether external balance is sustainable, with the answers ‘Yes’ and ‘No’ defining the two columns. At the side we ask whether internal balance is sustainable, with the answers defining the two rows. External balance is placed at the top to signify that we have a clearer picture of that than of internal balance. The main purpose of the internal balance indicators is to suggest that countries in box 3 are likely to slide to the right if internal balance is not achieved. It is also likely that it will be easier to move down the matrix, with internal balance being threatened by inefficient budgetary considerations and political pressures,

46 Macroeconomic Policy and Institutions

Is the external balance sustainable?

Is the internal balance sustainable?

Yes (1) Yes

MAFAS Success PPEER

No (2)

Real devaluation

Success

(3) No

PPERR? Failure Excess deficit procedure (EDP)

MAFAS?

Failure

(4) EU loan World Bank/IMF adjustment programme

Figure 1.2 Policy matrix Source: Branson and Braga de Macedo (1995).

than it will be to move up. This points to the need for institutional reform, as discussed in the second section. Countries in box 1 have already or are about to converge with the EU accession requirements in terms of both external and internal balance, and are in a position to adopt a MAFAS and PPERR. Countries in box 4 are out of balance on both dimensions, and are candidates for an EU loan or an IMF/World Bank structural adjustment programme to get close enough to the trajectory to consider a MAFAS and PPERR. Countries in boxes 2 and 3 in the policy matrix are in balance on one front but out of balance on the other, with some discrete adjustment being needed to get close to the convergence trajectory. Countries in box 2 may require a discrete real devaluation to restore external balance before adopting a PPERR. They may want to adopt a form of MAFAS that will create the resource freedom to ensure that the devaluation has the intended effect. Countries in box 3 may require the front-loaded application of a kind of ‘excessive deficit procedure’ (as called for by the EU Treaty for member states) as part of their MAFAS. Their PPERR may allow for some real appreciation as the excessive deficit procedure takes hold. Successful adjustment in boxes 2 and 3 will move the country to box 1, close enough to the convergence trajectory to sustain a MAFAS and PPERR. Failed adjustment will lead to box 4 and the need for an adjustment programme with outside assistance and conditionality.

William H. Branson, Jorge Braga de Macedo and Jürgen von Hagen 47

Conclusion The four CE countries are placed in the middle of the current EU grouping in terms of market and policy-making institutions. The main point of this statement is to suggest that they are institutionally better fit for fiscal consolidation and hence for EU membership than Greece, Spain and Portugal were in the 1970s. Nevertheless there is still considerable room for institutional improvement. A stronger commitment mechanism to fiscal targets at the preparatory stage would improve the fiscal performance of all four countries. In the Czech Republic and Poland, reforms of the budget process may be useful to address the relative weakness of the preparatory stage. In Poland, Slovakia and Hungary the relatively weak position of the government compared with the legislature is probably the weakest point in the current process. Even before the accession negotiations began the four countries were already close to sustainability in terms of the policy matrix in Figure 1.2. As they were closer to EU procedures and performances on macroeconomic, structural and institutional grounds than other EU candidates, and closer than some current member states had been before accession, they could have considered both a MAFAS and a PPERR. The fact that they had established CEFTA (which other accession countries later joined) suggests that they could have adopted a group convergence procedure. Such group procedure would have made their ‘converging European transitions’ more credible than those of other current or past EU candidates. Braga de Macedo (2000) finds this convergence and its sustainability a proxy for positive governance response to globalization. This is why the macroeconomic indicators used in the policy matrix should be supplemented by governance indicators such as the international credit rating and an index of apparent corruption. In spite of the progress achieved in acquis-related public investment and regulatory reforms, group procedures are unlikely to be adopted before the accession of the ten new members. The convergence process remains vulnerable. Note 1. This chapter is a revised version of the article ‘Macroeconomic Policy and Institutions in the Transition to EU Membership’ by the same authors, published in Ronald MacDonald and Rod Cross (eds), Central Europe Towards Monetary Union: Macroeconomic Underpinnings and Financial Reputation (Boston: Kluwer Academic Publishers, 2000, ISBN 0–7923–7967–5), pp. 5–30. With permission of Kluwer Academic Publishers.

References Alesina, Alberto and Allan Drazen (1991) ‘Why Are Stabilizations Delayed?’, American Economic Review, vol. 81, no. 5, pp. 1170–88. Alesina, Alberto, Ricardo Hausmann and Ernesto Stein (1996), ‘Budget Institutions and Fiscal Performance in Latin America’, NBER Working Paper W5586, May.

48 Macroeconomic Policy and Institutions Auerbach, Alan, Larry Kotlikoff and Willi Leibfritz (eds) (1999) Generational Accounting Around the World (Chicago, Ill.: Chicago University Press). Bliss, Christopher and Jorge Braga de Macedo (eds) (1990) Unity with Diversity in the European Economy: The Community’s Southern Frontier (Cambridge: Cambridge University Press). Braga de Macedo, Jorge (2000) ‘Converging European Transitions’, The World Economy, vol. 23, no. 10, pp. 1335–65. Braga de Macedo, Jorge and Helmut Reisen (2003) ‘Float in order to Fix? Lessons from Emerging Markets for EU Accession countries’, OECD Development Centre webdoc no. 9 (March). Branson, Willam H. and Jorge Braga de Macedo (1995) ‘Macroeconomic Policy in Central Europe’, CEPR Discussion Paper no. 1195 (London: Centre for Economic Policy Research). Branson, William H. and Dwight M. Jaffee (1991) ‘The Globalization of Information and Capital Mobility’, in Joshua Ronan and Joshua Livnat (eds), Accounting and Financial Globalization (Westport, CT: Quorum Books). Branson, William H. (1996) World Bank Support for Structural and Sectoral Adjustment: the Second OED Overview (Washington, DC: World Bank). Cohen, Daniel (1985) ‘How to Evaluate the Solvency of an Indebted Country’, Economic Policy, vol. 1, no. 1, pp. 140–160. Frankel, Jeffrey and Alan MacArthur (1988) ‘Political vs currency premia in international real interest differentials’, European Economic Review, vol. 32, pp. 1083–1118. Hallerberg, Mark and Jürgen von Hagen (1997) ‘Electoral Institutions, Cabinet Negotiations and Government Deficits in the EU’, CEPR Discussion Paper no. 1555 (London: Centre for Economic Policy Research). Mundell, Robert A. (1962) ‘The Appropriate Use of Monetary and Fiscal Policy under Fixed Exchange Rates’, IMF Staff Papers (Washington, DC: IMF). Poterba, James and Jürgen von Hagen (eds) (1999) Fiscal Institutions and Fiscal Performance (Chicago, Ill.: University of Chicago Press for the NBER). Velasco, Andres (1999) ‘A Model of Endogenous Fiscal Deficits and Delayed Fiscal Reforms’, in J. Poterba and J. von Hagen (eds), Fiscal Institutions and Economic Performance (Chicago, Ill.: University of Chicago Press for the NBER). von Hagen, Jürgen (1992) Budgeting Procedures and Fiscal Performance in the EC, DG II Economic Papers 96 (Luxembourg: European Commission). von Hagen, Jürgen and Ian Harden (1994) ‘National Budget Processes and Fiscal Performance’, European Economy Reports and Studies, vol. 3, pp. 311–418. von Hagen, Jürgen and Ian Harden (1996) ‘Budget Processes and Commitment to Fiscal Discipline’, IMF Working Paper, WP/96/78 (Washington, DC: IMF). Wildavsky, Aaron (1975) Budgeting. A Comparative Theory of Budgetary Processes (Boston, Mass.: Little, Brown).

2 Exchange Rate Policy in Central and Eastern Europe in the Context of EU Accession1 George Kopits

This chapter examines whether it is desirable for, and the ability of, the Central and Eastern European candidates for accession to the European Union (EU) to participate in the new exchange rate mechanism (ERM-2), and eventually in the economic and monetary union (EMU). For most of these countries the benefits of participating in EMU are likely to outweigh the costs. The key conditions for operating within ERM-2 include wage flexibility, a prudent fiscal and monetary stance, and a sound financial system. Once they have met these conditions the candidates will be able to shadow the euro prior to formal participation. The chapter concludes with a discussion of two policy dilemmas.

Introduction Economic and monetary union (EMU) is of central importance for the countries of Central and Eastern Europe (CEE) that are aspiring to join the EU. Whereas participation in EMU is not a formal requirement for EU membership, by the time of accession these countries will be expected to be on the way to meeting the criteria for EMU participation.2 Indeed the new member states will have to adopt the acquis communautaire of stage 2 of EMU, including adherence to the relevant provisions of the Stability and Growth Pact. They will also be expected to have liberalized capital movements, achieved central bank independence,3 and will be required to participate in the new exchange rate mechanism (ERM-2). Under the terms of the Stability and Growth Pact, non-participant (‘opt-out’ and ‘left-out’) EU members are required to submit medium-term convergence programmes for surveillance by the European Council. In addition, under ERM-2 they are required to maintain parity between their currency and the euro within a plus or minus 15 per cent margin for at least two years prior to qualifying for stage 3 of EMU. It can therefore be inferred 49

50 Exchange Rate Policy

that a basic – albeit implicit – prerequisite for EU accession is demonstration of the ability to operate within the ERM-2 regime and to eventually participate in EMU. Presumably there would also have to be credible convergence towards the EMU reference values for government deficit and debt, as well as for inflation and interest rates. This chapter seeks to answer the following questions about the implications of EMU for the CEE EU-accession candidates. Based on the theory of optimum currency areas, is there a case for EMU participation by these countries? If so, are these countries equipped to join the ERM-2 regime, and more generally to embark on a hard currency strategy? Above all, what are the necessary conditions for these countries to enter and operate within ERM-2? The chapter concludes with a discussion of two policy dilemmas faced by the candidates when coverging towards EMU. Although the chapter focuses on the initial leading accession countries (the Czech Republic, Estonia, Hungary, Poland and Slovenia), the main conclusions are also applicable to other candidates; moreover in some respects they are relevant for all transition economies in the region.

The case for participating in EMU The economic case for joining the ERM-2 regime, and for eventually participating in EMU, rests primarily on the theory of optimum currency areas – assuming, of course, that EMU is an optimum currency area.4 The relevance of this theory for the accession countries transcends the familiar debate on fixed versus flexible exchange rates for economies in transition.5 The dominant view in that debate is that during the transition from central planning to a market economy, a fixed peg can serve as a policy anchor for macroeconomic stabilization while the necessary institutional framework, including market-based hard budget constraints, is being developed. An alternative view is that a flexible rate can be useful for maintaining external competitiveness and serve as a more immediate gauge for macroeconomic discipline without constraining the transformation of the economy. These arguments seem less germane to the leading candidates than to some other transition economies that still face strong destabilizing forces and have insufficiently developed institutions and macroeconomic policy instruments. When assessing the applicability of the theory of optimum currency areas to the accession countries it is necessary to examine the benefits and costs that are likely to accrue to these countries upon entering the EMU currency area – which will, of course, be above and beyond the welfare effects of joining the EU as a customs union or a single market. As is well known, the benefits will primarily stem from the reduced cost of conducting economic transactions (trade, investment and services) with the existing currency area. Also, currency risk premia, including the risk of exchange rate depreciation, will lessen and ultimately vanish in those countries. The reduced transaction

George Kopits 51

and information costs and the declining currency risk premia will in turn lead to a permanent surge in trade, investment, employment and growth. An important potential cost of joining a currency area is impairment of the participant country’s ability to absorb asymmetric real shocks in the absence of an independent monetary or exchange rate policy – an increasingly unlikely prospect for most EU members.6 In principle this impairment of the macroeconomic stabilization function can be more than negligible for economies in transition that experience fiscal stress during EU accession as they attempt both to finance the costs of meeting the single market requirements and to move towards budgetary balance – or a deficit of less than 3 per cent of GDP. The candidate country might even be compelled to adopt a procyclical fiscal policy stance when faced with an adverse asymmetric shock.7 In addition it may lack sufficient flexibility in its internal goods and labour markets8 to serve as a shock absorber. In general the net benefits from joining an optimal currency area will be larger: (a) the smaller the size of the candidate country relative to the union, (b) the higher the degree of economic and political integration between the candidate and the union, (c) the stronger the similarity in economic structure between the candidate and the union, and (d) the larger the public indebtedness of the candidate country. Characteristics (a), (b) and (c) reduce the likelihood of asymmetric shocks in the enlarged union that need to be offset by means of policy action at the country level. Furthermore a major up-front gain, in the form of a significant reduction in exchange rate risk premia, accrues under (d) – as experienced, for example, by Italy during its convergence to EMU. In view of the brief and historically unique track record during postsocialist transition, it is difficult to predict the net effect of participating in EMU for the leading accession countries. The only attempt at a quantitative assessment of the likely effect for any of these countries suggests that Slovenia (the candidate with the highest income level) would derive a net benefit from joining the euro area.9 Nevertheless, to some extent all five candidates stand to gain from characteristics (a) to (c), and a couple of candidates from (d). These economies are relatively small and have already achieved a considerable degree of economic integration with the EU, as reflected in the share of their trade (that is, exports plus imports, divided by two) with the EU in proportion to GDP (Figure 2.1). In fact they are at least as open to trade with the EU as a number of non-core EU members (except Ireland), and more so than Greece and Italy. Integration through factor flows is less impressive: although most of the leading candidates are recipients of significant direct investment in relation to GDP, mainly from the EU, the scope for crossborder labour mobility has been limited for the most part to informal channels. In addition, important steps towards political integration (for example OECD and NATO membership) have been taken earlier by three of the candidates (the Czech Republic, Hungary and Poland).

52 Exchange Rate Policy Estonia Hungary Czech Republic Slovenia Poland Ireland Portugal Spain Italy Greece 0

10

20 At market prices

30

40

50

60

At purchasing power standards

Figure 2.1 Trade with the European Union, selected countries, 2000 (percentage of GDP)

When ranked according to per capita GDP (in descending order), the economic structure of most candidates (expressed in terms of the sectoral distribution of gross value-added or labour force) is only slightly more skewed towards agriculture and industry than that of non-core EU members, except Greece (Figure 2.2).10 The three-way sectoral breakdown glosses over the diverse manufacturing base of these accession countries, which further reduces their susceptibility to asymmetric shocks.11 Therefore on the basis of their size, integration and structure, most candidates are likely to benefit from entering the euro area. In addition Hungary and Poland should gain more than the other three candidates from the decline in the risk premia and interest costs – already observable in narrowing spreads, in anticipation of accession – associated with a relatively high level of public debt. However the assumption that for any country, let alone a CEE candidate, vulnerability to asymmetric shocks can be ascertained on the basis of accumulated historical data is questionable. In fact trade and factor movements, as well as income or output correlations, between potential and actual participants of a currency area are endogenous to participation (or anticipated participation) in that area. The observed strong relationship between trade intensity and cross-country correlation of business cycles implies a self-reinforcing process. As trade intensifies the probability of asymmetric shocks declines; conversely participation in a currency area leads to trade expansion and thus to increasingly synchronized cycles.12 Moreover, arguably, even without the immediate prospect of accession, the similarities between CEE candidates and EU members are bound to increase over time. In sum, for the five leading accession countries the benefits can be expected to outweigh the costs of joining EMU in the medium term.

George Kopits 53 80 70 60 50 40 30 20 10 0 Greece Portugal Spain Labour force Agriculture

Industry

Italy

Ireland

Services

Poland Estonia Hungary Czech Slovenia Republic Value added Agriculture Services Industry

Figure 2.2 Distribution of value added and labour force, selected European countries, 1998 (percentage of total)

Exchange rate system and macroeconomic framework After the collapse of central planning most transition economies sought to eliminate the accumulated monetary overhang by liberalizing prices (including the exchange rate, interest rates and wages) and external trade, attempting to curb monetary expansion, and containing the budget deficit. At the outset these steps were accompanied by a sharp depreciation (including overshooting) of the exchange rate. Thus early in the transition process, when faced with continued inflation pressures and lacking sufficiently developed indirect macroeconomic instruments, a number of countries (including the Czech Republic, Estonia and Poland) chose to anchor their policies with a fixed exchange rate. Others (Hungary and Slovenia), starting from a position closer to macroeconomic balance, adopted a more flexible exchange rate system. Exchange-rate-based stabilization programmes helped to restore domestic equilibrium, though in some cases at the cost of an increased current account imbalance financed largely by means of debt-creating capital inflows. Eventually Poland and the Czech Republic were forced to abandon the fixed peg. Whereas the former did so in the initial stage of the transition, the latter acted at a later stage in response to a currency crisis – reflecting insufficient progress in economic restructuring and weak fundamentals that made it susceptible to speculative attacks.13 In the mid 1990s, when confronted with untenable external and fiscal imbalances and with its policy

54 Exchange Rate Policy

credibility eroded, Hungary could no longer rely on an adjustable peg. As part of a stabilization programme it switched to a pre-announced crawling peg regime, much like Poland had done a few years earlier. With their credibility largely restored, most of the leading accession countries have increasingly relied on flexible exchange rate arrangements, in combination with inflation targeting (Table 2.1). At one end of the spectrum, Poland has adopted a freely floating exchange rate, along with rather strict inflation targeting, under the authority of a fairly independent central bank. At the other extreme, Estonia has persevered successfully with its currency board arrangement, which was originally pegged to the Deutschmark and now to the euro. Thus, Estonia can be said to have participated de facto in the euro area from the very outset. Differences in exchange rate arrangements notwithstanding, all five accession countries considerably liberalized their external current accounts in the initial stages of transition, securing Article VIII status with the IMF, and all have become members of the WTO. Their average nominal and effective rates of protection are low by international standards.14 A small import surcharge, adopted at various times by the Czech Republic, Hungary and Poland, has been phased out. Most candidates have achieved a fair degree of openness in the capital account as well. For the Czech Republic, Hungary and Poland this step was instrumental in gaining membership of the OECD. Among the last remaining restrictions were those on short-term capital inflows (Poland) and on resident accounts held abroad (Slovenia). For the purpose of conducting monetary policy and supporting their exchange rate arrangements, the accession countries have increasingly Table 2.1 Accession countries, exchange rate and monetary framework, 2001

Country Czech Republic Estonia Hungary

Exchange rate regime

Monetary policy

Managed float

Inflation targeting Currency board arrangement Inflation targeting Inflation targeting M3 targeting

Fixed peg

Poland

Peg with margins (⫹/⫺15 per cent) Free float

Slovenia

Managed float

Central bank independence (index)1

Exchange and capital restrictions (index)2

0.7

0.2

0.8

0.1

0.7

0.1

0.9

0.4

0.6

0.3

Notes 1. Index value ranges from 0 (lowest) for lack of autonomy, to 1 (highest) for full independence (see Cukierman et al., 2002). 2. Index value ranges from 0 (lowest) for absence of controls, to 1 (highest) for full restriction (see underlying methodology in Tamirisa, 1999).

George Kopits 55

relied on indirect market-based instruments. Along with significant central bank independence – occasionally threatened by the executive or legislative branches of government – they have strictly limited or even prohibited the direct financing of government budget deficits. Early on they all introduced legal reserve requirements and their central banks have actively engaged in repurchase agreements and open market operations. Besides intervening through outright foreign exchange sales or purchases, each country has sought at various times to contain the monetary impact of capital movements through sterilized intervention. Given the openness of the capital account, these interventions have met with limited success – and have often been at significant cost.15 However such practices have been discontinued in most countries; only occasionally do the authorities still resort to intervention to dampen large exchange rate fluctuations. The current macroeconomic situation in the accession countries is broadly characterized by sustainable growth, underpinned by rapidly increasing labour productivity, a slowdown in inflation to single-digit rates and moderate external current account imbalances, financed largely through direct investment inflows (Table 2.2). In several respects the exchange rate regime has played a significant role in this performance. Table 2.2 Accession countries, selected performance indicators, 1993–99 (annual percentage change, unless otherwise indicated) 1993 1994 1995 1996

1997

Czech Republic Real GDP growth 0.6 2.2 5.9 4.8 ⫺1.0 Labour productivity in 3.7 4.9 11.1 9.6 11.1 manufacturing CPI inflation (year end) 18.2 9.7 7.9 8.6 10.0 Unemployment rate (percentage of 3.5 3.2 2.9 3.5 5.2 labour force, year end) External current account balance 1.3 ⫺1.9 ⫺2.6 ⫺7.4 ⫺6.1 (percentage of GDP) Foreign direct investment, net 1.6 1.8 4.9 2.2 2.4 change (percentage of GDP) Estonia Real GDP growth ⫺9.0 ⫺2.0 4.6 4.0 10.4 Labour productivity in – 6.7 0.4 7.8 27.4 manufacturing CPI inflation (year end) 35.6 41.7 28.9 14.8 12.5 Unemployment rate (percentage of 6.6 7.6 9.8 10.0 9.7 labour force, year end)1 External current account balance 1.3 ⫺7.2 ⫺4.4 ⫺9.2 ⫺12.1 (percentage of GDP) Foreign direct investment, net 10.0 9.2 5.6 2.5 2.6 change (percentage of GDP)

1998 1999 ⫺2.2 ⫺0.4 5.6 2.2 6.8 7.5

2.5 9.4

⫺2.3 ⫺2.9 6.3

11.4

5.0 ⫺0.7 9.4 4.6 6.5 9.9

3.9 12.4

⫺9.2 ⫺4.7 11.0

4.3

56 Exchange Rate Policy Table 2.2 Continued 1993 1994 1995 1996 Hungary Real GDP growth ⫺0.6 2.9 1.5 Labour productivity in 6.5 7.3 11.2 manufacturing CPI inflation (year end) 21.1 21.2 28.3 Unemployment rate (percentage 12.1 12.4 12.1 of labour force, year end) External current account balance ⫺9.0 ⫺9.4 ⫺5.6 (percentage of GDP) Foreign direct investment, net 6.0 2.6 9.9 change (percentage of GDP) Poland Real GDP growth 3.8 5.2 7.0 Labour productivity in 15.0 13.9 7.0 manufacturing CPI inflation (year end) 37.6 29.5 21.6 Unemployment rate (percentage 16.4 16.0 14.9 of labour force, year end) External current account balance ⫺0.7 0.7 4.5 (percentage of GDP) Foreign direct investment, net 0.7 0.6 0.9 change (percentage of GDP) Slovenia Real GDP growth 2.8 5.3 4.1 Labour productivity in industry 5.8 11.4 7.2 CPI inflation (year end) 22.8 19.5 9.0 Unemployment rate (percentage of 9.1 9.1 7.4 labour force, year end)1 External current account balance 1.5 4.0 ⫺0.5 (percentage of GDP) Foreign direct investment, net 0.9 0.9 1.0 change (percentage of GDP)

1997

1998 1999

1.3 3.3

4.6 13.0

4.9 10.1

4.2 0.2

19.8 11.8

18.4 11.6

10.3 10.1

11.2 9.9

⫺3.7

⫺2.1

⫺4.9 ⫺4.3

5.0

3.8

3.3

3.6

6.0 10.0

6.8 12.1

4.8 4.7

4.1 9.5

18.5 13.2

13.2 8.6

8.6 10.4

9.8 13.0

⫺1.0

⫺3.2

⫺4.4 ⫺7.5

1.9

2.1

3.1

4.1

3.5 6.7 9.0 7.3

4.6 4.5 8.8 7.1

3.8 5.4 6.5 7.6

5.2 1.8 8.0 7.4

0.2

0.1

1.0

1.9

⫺0.8 ⫺3.9 1.3

0.7

Note 1. Labour market data based on ILO methodology. Sources: EBRD; IMF.

After the initial concern with containing inflationary pressures, exchange rate policy was increasingly governed by the twin objectives of price stability and external competitiveness, and more generally by the need to strengthen overall policy credibility. From this perspective, both Hungary and Poland have managed to restore competitiveness and achieve credibility in terms of fundamentals with the introduction of a preannounced crawl.16 Evidence of increased credibility in both countries can be found in the rapid convergence of exchange rates in the forward market to the preannounced rate, as well as the decline in domestic interest rates and a

George Kopits 57

pivoting of the yield curve on government paper in favour of long-term maturities.17 While perhaps less transparent, implementation of the managed float in the Czech Republic and Slovenia has had similar salutary effects. In all these countries disinflation has continued to be a priority goal, pursued in recent years by means of formal or informal inflation targeting. As an outlier, Estonia has been particularly remarkable in achieving both high growth and low inflation during the country’s prolonged adherence to the fixed peg regime.

Determinants of exchange rate movements For the purpose of assessing the accession countries’ future ability to operate under the ERM-2 regime, it is necessary to examine the likely pressures (and their relative strengths) on the nominal exchange rate within the allowed margin. In the accession countries the main sources of pressure on the exchange rate have been productivity performance, wage formation, fiscal and monetary policy stance, the soundness of financial institutions and outside shocks. Productivity performance in the tradables sector is a well-known determinant of the long-term equilibrium real exchange rate in relatively lowincome economies. Gains in labour productivity in the tradables sector give rise to an increase in wages, including those in the non-tradables sector; this leads to an increase in the domestic price level compared with the price level abroad, which is reflected in an appreciation of the (relative price-based) real exchange rate. Real appreciation is manifest in an upward pressure on the nominal exchange rate or the price level, or both. This productivity effect or bias – known as the Harrod–Balassa–Samuelson effect – has been observed during the convergence of some low-income economies to the advanced economies.18 But nowhere has the scope of this effect been as great as in the economies in transition, which had operated so inefficiently under several decades of socialist central planning.19 These economies show considerable potential for major improvements in allocative and X-type efficiencies – mainly in export activities and import-competing activities – as they open up to competition from abroad. The effect has been compounded by a surge in foreign direct investment, much of it attracted by the tradables sector, especially in the advanced accession countries that were engaged in rapid industrial restructuring. On the other hand these economies are also experiencing an overall increase in supply as a result of the economy-wide building and upgrading of infrastructure, which could lead to a decline in the domestic price level, reflected in a real depreciation. Unless the output increase is accompanied by a rise in the wage level, this depreciation may offset part of the appreciation from productivity gains in the tradables sector.20 Wage formation can exert a significant influence on the nominal exchange rate without necessarily bearing any consequences for the real rate. Wage

58 Exchange Rate Policy

increases that are systematically in excess of productivity increases, especially in the context of a (backward-looking) wage indexation mechanism, tend to get built into expectations. These increases, usually accommodated by monetary policy, have a depressing effect on the exchange rate. (Alternatively a fixed nominal rate results in real overvaluation, above the equilibrium rate, ultimately calling for a devaluation to correct the disequilibrium.) There have been many high-inflation episodes in developing countries where the underlying source was full wage indexation that could only be corrected by an exchange-rate-based stabilization programme. Less dramatic has been the experience of some EU members in the Mediterranean region, notably Greece and Italy, where wage indexation led to successive devaluations. Although none of the CEE candidates has a formal wage indexation mechanism,21 some have been exposed to wage drift or a form of implicit wage indexation.22 The effect of the fiscal policy stance on the exchange rate depends primarily on whether or not it is monetized – as shown in the basic Mundell–Fleming model. If monetized, as was the practice in the past in some candidate countries, fiscal expansion has a downward effect on the exchange rate. If not monetized, the increased government borrowing requirement results in upward pressure on interest rates and the exchange rate, crowding out domestic investment and net exports. However, with uncertainty of expectations and an intertemporal budget constraint, lasting fiscal expansion will contribute to exchange rate depreciation.23 The increase in the budget deficit, accompanied by anticipation of a rise in public indebtedness and possibly its future monetization, leads to an increase in currency risk and default risk premia embedded in the domestic interest rate. The ensuing decline in riskier asset holdings explains both the rise in domestic interest rates and the downward pressure on the exchange rate. This latter explanation seems most relevant for the CEE candidates, especially those with a relatively high public debt to GDP ratio. The exchange rate may also be influenced by shifts in private domestic absorption financed by foreign capital inflows. Depending on whether a surge in domestic demand is directed primarily at non-tradables, it can lead to real appreciation. In this respect, in the early phase of transition the large proportion of portfolio foreign investment used to finance private consumption, mainly of non-tradables, may partly explain the initial real appreciation experienced by some of these economies.24 By contrast the increasing volume of direct investment in the leading candidates, used mainly to finance machinery and equipment imports, should have had no discernible effect on the exchange rate.25 Clearly, in the short term an economy’s monetary policy stance – in tandem with the above determinants – can have a major impact on the exchange rate. Under a fixed peg and an open capital account the monetary instrument is simply used to support the peg through interest rate adjustments

George Kopits 59

and other forms of intervention. However under a managed or flexible exchange rate regime (including with wide bands around a central rate), monetary policy plays an active role. In several accession countries this role has become all the more relevant with the adoption of inflation targeting. In addition to policy fundamentals, the exchange rate responds to changes in differential risk-adjusted rates of return on comparable financial assets denominated in domestic and foreign currencies.26 Sudden shifts in perceptions of risk can contribute to capital movements and exchange rate volatility – a situation that is not uncommon in emerging markets (including economies in transition) with an open capital account. These changes in risk premia can be associated with a reassessment of the above fundamentals, or with new information about structural conditions in the economy. In this regard the soundness of the financial system, including its implications for the real side of the economy, takes on crucial importance. Although considerable progress has been made in restructuring commercial banks, including their privatization, a few accession countries have yet to complete the clean-up of non-performing portfolios and to impose hard budget constraints on financial institutions. Shifts in investor sentiment and perceptions of risk are often shaped by exogenous shocks due to developments outside the country. This is particularly the case in emerging markets where a currency or financial crisis in one country or region can spread rapidly to other countries that are deemed to have comparable risk-return characteristics.27 Again, given their external openness, the accession countries have been vulnerable to such contagion effects, transmitted through financial flows and, to a lesser extent, trade flows.

Country experience The above discussion provides a basis for assessing the extent to which exchange rate movements in the accession countries reflect the relative influence of each determinant. Such an assessment would indicate the sort of pressures that are likely to support, or prevent, a candidate’s adherence to the ERM-2 regime. Unfortunately the limited sample period precludes econometric estimates to explain exchange rate fluctuations in terms of key determinants – a deficiency that cannot be satisfactorily offset by pooled cross-country observations, given the heterogeneity of the sample over the transition period. Instead it is necessary to capture the relative importance of those determinants by examining fluctuations in real and nominal effective exchange rates during relevant episodes in each candidate economy. Movements in the nominal exchange rate over time may reflect the cumulative pressures that drive the rate towards equilibrium. More immediately, these pressures usually become apparent in the real rate. Assuming an initial

60 Exchange Rate Policy

position of equilibrium, upward (downward) deviations in the real rate can be interpreted as prima facie evidence of overvaluation (undervaluation) and of downward (upward) pressures on the nominal rate, which would argue for a nominal depreciation (appreciation). Conversely deviations in the nominal rate while the real rate remains invariant suggest that equilibrium is maintained through nominal exchange rate adjustments. This interpretation is generally valid for a relative unit labour cost-based (ULC-based) real exchange rate index, free of the productivity bias mentioned above, in contrast with a relative price-based (CPI-based) real exchange rate index that reflects the bias. Admittedly any real rate index provides only a rough gauge for deviations from equilibrium in a country undergoing deep structural transformation, as experienced by the accession economies.28 At best the start of the index should be set after macroeconomic adjustment (including exchange rate overshooting) at the outset of transition. Also it is more meaningful to concentrate solely on exchange rate changes after the completion of a critical mass of external liberalization and domestic restructuring – despite there still being some pending restructuring tasks in several countries. Although selected on the basis of such considerations, the base period (January or the first quarter of 1993) for the monthly or quarterly index cannot be taken as anything more than a crude approximation of the equilibrium real exchange rate. By the same token, fluctuations in real effective indexes (Figures 2.3–2.7) can only be regarded as illustrating broad trends – rather than being an accurate portrayal of actual developments – in the late 1990s.29 It should be noted that while the CPI-based index tracks consistently above the ULC-based index, the difference cannot be attributed solely to productivity bias. Indeed the relatively small difference (as observed for the Czech Republic and Slovenia) does not merely reflect lagging productivity improvement (Table 2.2), but also the prevalence of price controls in certain activities (mainly non-tradables) during that period. Subject to these caveats, perhaps the most salient finding is the apparent relationship between variations in relative unit labour costs and those in the nominal effective exchange rate index across countries. Although all countries enjoyed significant labour productivity gains in manufacturing (accounting for the bulk of the tradables sector), these gains were often more than offset by wage awards. The cases of Poland, where relative unit labour costs doubled over the period in question, and Slovenia, where they increased by some 60 per cent, illustrate the strong downward pressure exerted by de facto wage indexation on the nominal exchange rate (Figures 2.3 and 2.4). In turn it appears that the flexibility provided by the crawling peg and the managed float, respectively, may have conditioned the wage demands of organized labour and prevented the authorities from reducing the rate of depreciation more rapidly.

61 250

200

150

100

50

0 1993

1994

1995

1996

1997

1998

Real effective exchange rate (ULC-based) Real effective exchange rate (CPI-based) Nominal effective exchange rate Relative unit labour costs Figure 2.3 Exchange rate and unit labour costs, Poland, 1993–98 (January 1993 ⫽ 100)

150

100

50

0 1993

1994

1995

1996

1997

1998

Real effective exchange rate (ULC-based) Real effective exchange rate (CPI-based) Relative unit labour costs Nominal effective exchange rate Figure 2.4 Exchange rate and unit labour costs, Slovenia, 1993–98 (January 1993 ⫽ 100)

62 150

100

50

0 1993

1994

1995

1996

1997

1998

Real effective exchange rate (ULC-based) Real effective exchange rate (CPI-based) Relative unit labour costs Nominal effective exchange rate Figure 2.5 Exchange rate and unit labour costs, Hungary, 1993–98 (first quarter 1993 ⫽ 100)

160

140

120

100

80 1993

1994

1995

1996

1997

1998

Real effective exchange rate (ULC-based) Real effective exchange rate (CPI-based) Nominal effective exchange rate Relative unit labour costs Figure 2.6 Exchange rate and unit labour costs, Czech Republic, 1993–98 ( January 1993 ⫽ 100)

George Kopits 63 200

150

100

50

0 1994

1995

1996

1997

Real effective exchange rate (ULC-based) Real effective exchange rate (CPI-based) Nominal effective exchange rate Relative unit labour costs Figure 2.7 Exchange rate and unit labour costs, Estonia, 1994–97 (first quarter 1994 ⫽ 100)

In Hungary fiscal policy played a dominant role in determining exchange rate fluctuations. Given the high level of public sector indebtedness (Table 2.3), changes in the fiscal stance influenced expectations about the sustainability of macroeconomic policies in general and the exchange rate in particular. Although not obvious in the indicators shown (Figure 2.5), the deterioration in the fiscal position, accommodated by a loose monetary stance, led to mounting downward pressure on the adjustable peg by early 1995. To correct the external imbalance and cool inflation expectations, the authorities embarked on a major fiscal consolidation and adopted the preannounced crawling peg, following a one-off devaluation. The Czech crisis of 1997 illustrates the degree to which an open economy with a weak banking system and unreformed enterprise sector, while subject to a fixed exchange rate, is vulnerable to shifts in investor confidence.30 The absence of hard budget constraints led to a significant accumulation of nonperforming bank loans (Table 2.3),31 and the lack of sufficient enterprise restructuring gave rise to larger wage increases than were warranted by productivity growth, which in turn led to an overvalued ULC-based real exchange rate (Figure 2.6). However, and notwithstanding the problems in the financial sector, the image of the Czech economy as a successful example of transition – in some respects comparable to the favourable image of the Asian ‘tigers’ – drove up the nominal exchange rate to the upper limit

64 Table 2.3 Accession countries, selected financial indicators, 1993–99 (percentage of GDP, unless otherwise indicated) 1993 1994 1995 1996 1997 1998 1999 Czech Republic General government balance1 Overall balance Primary balance Gross public debt2 Short-term interest rate (per cent, year end) M2/foreign exchange reserves (per cent, year end) Share of non-performing loans (percentage of total) Estonia General government balance1 Overall balance Primary balance Gross public debt Short-term interest rate (per cent, year end)3 M2/foreign exchange reserves (per cent, year end) Share of non-performing loans (percentage of total) Hungary General government balance1 Overall balance Primary balance Gross public debt Short-term interest rate (per cent, year end) M2/foreign exchange reserves (per cent, year end) Share of non-performing loans (percentage of total) Poland General government balance1 Overall balance Primary balance Gross public debt Short-term interest rate (per cent, year end) M2/foreign exchange reserves (per cent, year end) Share of non-performing loans (percentage of total)

0.6 ⫺1.2 ⫺1.8 ⫺1.2 ⫺1.9 ⫺3.0 ⫺3.7 2.2 0.0 ⫺0.7 ⫺0.2 ⫺0.6 ⫺1.8 ⫺2.6 15.8 13.8 11.5 19.6 20.1 19.6 23.3 8.0 12.7 10.9 12.7 17.5 10.1 5.6 6.2

4.9

–

–

⫺0.6 ⫺0.6 – 30.4

2.9 26.6

3.4

3.5

3.2

2.7

21.8 19.9 20.3

21.5

1.3 ⫺1.2 ⫺1.5 2.2 ⫺0.3 ⫺4.6 1.3 ⫺1.0 ⫺1.1 2.7 0.2 ⫺4.2 – 5.7 6.9 7.6 6.4 7.3 25.2 15.3 13.8 15.8 18.5 5.1

1.4

1.6

1.6

1.9

1.9

2.0

2.0

7.0

3.5

2.4

2.0

2.1

4.0

2.9

⫺7.8 ⫺8.6 ⫺6.2 ⫺3.1 ⫺4.8 ⫺4.8 ⫺3.7 ⫺3.3 ⫺2.7 2.1 4.3 3.0 1.6 2.7 88.7 86.0 85.1 74.1 62.9 61.1 60.0 21.8 31.3 27.8 23.2 19.7 17.3 14.5 2.6

2.7

1.4

1.8

2.1

2.3

2.0

29.6

20.2

12.1

9.0

5.3

6.8

4.4

⫺3.4 ⫺3.2 ⫺3.2 ⫺3.6 ⫺3.2 ⫺3.3 ⫺3.4 0.1 1.0 1.6 0.4 0.5 ⫺0.1 ⫺0.3 86.0 69.0 55.5 49.4 46.9 42.9 44.5 33.7 33.0 29.0 26.0 28.0 15.5 16.5 6.6

5.5

2.9

36.4

34.0

23.9

2.7

2.5

2.1

2.4

14.7 11.5 11.8

14.5

George Kopits 65 Table 2.3 Continued 1993 1994 1995 1996 1997 1998 1999 Slovenia General government balance1 Overall balance Primary balance Gross public debt Short-term interest rate (per cent, year end) M2/foreign exchange reserves (per cent, year end) Share of non-performing loans (percentage of total)

0.9 2.2 21.1 34.7

0.0 1.5 18.6 24.7

0.1 1.3 18.8 15.9

4.3

3.3

3.6

19.0

13.8

9.3

0.4 ⫺1.1 ⫺0.6 ⫺0.6 1.6 0.1 0.7 0.8 22.7 23.5 23.7 24.5 10.2 9.8 5.6 6.9 3.1

2.2

2.6

2.8

10.1 10.0

9.5

8.6

Notes 1. Excluding revenue from privatization. 2. Central government until 1995. 3. Three- to six-month lending rates until 1996. Sources: EBRD; IMF.

of the band (7.5 per cent above or below the official parity) that prevailed in mid 1997. But then, in the wake of the Asian crisis, sudden awareness of the underlying financial weaknesses prompted a shift in investors’ perception of risk, resulting in sizeable capital outflows. After an attempt to defend the exchange rate the authorities abandoned the peg and tightened fiscal and monetary policies. The experience of Estonia can be regarded as an exceptional case among the leading accession countries on account of its geopolitical situation, small size, historical background and macroeconomic policies. Consistent with the currency board arrangement, the budget was kept near balance or in surplus during most of the decade, while wage setting remained flexible. The combination of extensive restructuring and adjustments in administered prices translated into a high inflation rate, which subsequently decelerated under the effect of the hard peg.32 On the external front, the large current account imbalance, accompanied by strong export growth, was indicative of buoyant domestic demand rather than a deterioration in competitiveness, as evidenced by the decline in the ULC-based real effective rate, while the recorded rise in the CPI-based index largely reflects the productivity bias (Figure 2.7). An issue that requires particular attention relates to the potential effects of exogenous shocks on the exchange rate and its volatility. In this respect it is useful to focus more closely on daily or monthly fluctuations in the nominal exchange rate and short-term interest rates in a period when these economies were exposed to the currency crises in Asia (June 1997), Russia

66 Exchange Rate Policy

(August 1998), Brazil (January 1999) and Ecuador (February 1999). The Czech Republic was hit hardest by the first crisis and Hungary by the second, while Poland experienced the effect of both, but to a significantly lesser extent.33 By contrast Estonia and Slovenia seem to have been largely immune from contagion effects. None of the accession countries was affected by the Brazilian and Ecuadorian crises or by those which erupted more recently. In fact risk premia (as reflected in interest differentials vis-à-vis Germany, adjusted for the rate of preannounced crawl, where appropriate) have declined markedly. In Poland the exchange rate came under pressure (falling below the central rate) in the second half of 1997, accompanied by a moderate rise in the short-term interest rate (Figure 2.8). Subsequently upward pressures prevailed as the band was widened and the rate of crawl was reduced, while the differential with the German interest rate increased briefly. In August 1998 the exchange rate again dropped towards the central rate, albeit without any need for intervention and allowing room for continued interest rate cuts and a further widening of the band by the end of October. In mid 1997 the Czech Republic unsuccessfully attempted to defend the exchange rate peg through massive intervention in the foreign exchange market and a sharp boost in the short-term interest rate (Figure 2.9). Later, with greater exchange rate flexibility and a significant tightening of financial policies the nominal rate returned to the initial parity and interest rates declined steadily. Hungary was unaffected by the Asian crisis but felt a tremor from the Russian crisis, as reflected in the market exchange rate being temporarily pushed to the bottom of the band, which was reversed with a significant rise in the short-term interest rate (Figure 2.10). Estonia and Slovenia – tracked using monthly data – represent a departure from the foregoing cases as both countries have been largely protected from the effects of crises. In Slovenia the tightening of capital controls obviated recourse to interest rate increases to support the exchange rate, which was allowed to depreciate slightly following the Asian crisis; in fact interest rates continued to decline even in the wake of the Russian crisis (Figure 2.11). In Estonia, despite the complete openness of the capital account, protection against potential speculative attacks was provided by the unshaken credibility of the currency board arrangement – tested over a prolonged period – and the lowest public debt to GDP ratio in the region (Figure 2.12; see also Table 2.2 above). By and large these episodes confirm that a country with some exchange rate flexibility, whether in the form of a wider band or a float, is in a better position to withstand pressures on the exchange rate from outside financial shocks. Attention to macroeconomic fundamentals and restructuring tasks is highly desirable in emerging market economies for preventing currency crises, but it is essential in those with a hard peg and a fully open capital account.

67 110 105 100 95 90 85 80 75 70 65 60 Spot exchange rate against basket Preannounced central rate (Jan. 1997 = 100), margins 30

25

20

15

10

5

Ja n. 19 Fe 97 b. 19 97 Ap r.1 99 7 Ju n. 19 Au 97 g. 19 97 O ct .1 99 7 D ec .1 99 7 Ja n. 19 98 M ar .1 99 M ay 8 .1 99 8 Ju l.1 99 Se 8 p. 19 98 N ov .1 99 8 Ja n. 19 99

0

3-month (annualized) Polish interest rate 3-month (annualized) German interest rate, including crawl Interest rate differential

Figure 2.8 Exchange rate and interest rates, Poland, January 1997 to February 1999

68 120 110 100 90 80 70 60 Spot exchange rate against basket Preannounced central rate (Jan. 1997 = 100), margins

35 30 25 20 15 10 5

Ja

n. 19 97 Fe b. 19 97 Ap r.1 99 7 Ju n. 19 97 Au g. 19 97 O ct .1 99 7 D ec .1 99 7 Ja n. 19 98 M ar .1 99 M ay 8 .1 99 8 Ju l.1 99 Se 8 p. 19 9 8 N ov .1 99 8 Ja n. 19 99

0

3-month (annualized) Czech interest rate 3-month (annualized) German interest rate Figure 2.9 Exchange rate and interest rates, Czech Republic, January 1997 to February 1999

69 105

100

95

90

85

80

75

70 Preannounced central rate (Jan. 1997 = 100), margins Spot exchange rate against basket 25

20

15

10

5

Ja n

.1 99 7 Fe b. 19 97 Ap r.1 99 7 Ju n. 19 97 Au g. 19 97 O ct .1 99 7 D ec .1 99 7 Fe b. 19 98 Ap r.1 99 8 Ju n. 19 98 Au g. 19 98 O ct .1 99 8 D ec .1 99 8 Fe b. 19 99

0

3-month (annualized) Hungarian interest rate 3-month (annualized) German interest rate, including crawl Interest rate differential

Figure 2.10 Exchange rate and interest rates, Hungary, January 1997 to February 1999

70 110

105

100

95 Spot exchange rate against the Deutschmark (Jan. 1997 = 100) 90

85

80 25

20

15

10

5

Ja n

.1 99 7 M ar .1 99 7 M ay .1 99 7 Ju l.1 99 7 Se p. 19 97 N ov .1 99 7 Ja n. 19 98 M ar .1 99 8 M ay .1 99 8 Ju l.1 99 8 Se p. 19 98 N ov .1 99 8 Ja n. 19 99

0

3-month (annualized) Slovenian interest rate 3-month (annualized) German interest rate

Figure 2.11 Exchange rate and interest rates, Slovenia, January 1997 to January 1999

71 110

100

Exchange rate against DM (Jan. 1997 = 100)

90

80 25

20

15

10

5

99 7 M ay .1 99 7 Ju l.1 99 7 Se p. 19 97 N ov .1 99 7 Ja n. 19 98 M ar .1 99 8 M ay .1 99 8 Ju l.1 99 8 Se p. 19 98 N ov .1 99 8 Ja n. 19 99

ar .1 M

Ja n

.1

99

7

0

3-month (annualized) Estonian interest rate 3-month (annualized) German interest rate

Figure 2.12 Exchange rate and interest rates, Estonia, January 1997 to January 1999

72 Exchange Rate Policy

The path to ERM-2 The picture that has emerged so far is one of diversity in the exchange rate regimes and experiences of the accession countries. Exchange rate developments reflect to a certain extent the effect of productivity gains in the tradables sector. However this effect has been outweighed in each country by a particular strength or weakness in terms of policy consistency. While wage indexation has been a major deficiency in Poland, and to a lesser extent in Slovenia, public sector deficits and indebtedness are the principal sources of Hungary’s vulnerability. Insufficient financial and enterprise restructuring have contributed to the fragility of the Czech economy. By contrast wage flexibility, fiscal discipline and substantial restructuring have lent strength to Estonia. All five countries have been served relatively well by their respective exchange rate regimes – especially with increased flexibility – when supported by appropriate flanking policies, as suggested by key performance variables. This is all the more remarkable in view of the large-scale internal transformation and external liberalization they have had to undertake. All candidates are poised to move towards the ERM-2, admittedly from different starting points. While there is no reason why they should follow a unique path, their exchange rate regimes are compatible with convergence to ERM-2 as long as they are applied in a consistent policy framework. Before touching on the operational aspects of entering the new mechanism it is necessary to focus on measures for coping with the risks ahead. On balance the greatest risk to adopting a hard currency strategy is downward pressure on the exchange rate from excessive wage increases and expansionary fiscal policies, accommodated by monetary ease, rather than upward pressure from labour productivity gains in the tradables sector. Another possible threat to exchange rate stability stems from weak financial intermediaries that service enterprises (either state-owned or nominally privatized) that are not yet fully subject to a hard budget constraint. There are numerous lessons to be learnt from around the world, including from some of the present EU members, that emphasize the need for consistency between the exchange rate system and other macroeconomic policies. The short-lived experience with the tablita in the southern cone of Latin America in the late 1970s was flawed by the inconsistency between the preannounced crawling peg and either a backward-looking wage indexation mechanism or a sizeable and prolonged fiscal imbalance.34 For similar reasons Greece was able to join the ERM only after most other EU members had done so, and Italy participated in the mechanism at the cost of frequent (downward) exchange rate realignments and the maintenance of relatively high interest rates. Therefore an indispensable step towards a hard currency strategy for Poland was the abandonment of wage indexation. Likewise in other accession countries it will be necessary to refrain from granting wage

George Kopits 73

awards that are unrelated to productivity performance or aimed at holding real wages constant. It is noteworthy that a concerted effort to maintain consistency between the pegged exchange rate and wage formation has been the keystone of Austria’s hard currency strategy for over two decades,35 well ahead of convergence to EMU. In Italy, after the dismantling of the scala mobile, a highly coordinated approach was adopted in 1993 that consisted of binding guidelines for industry and firm-level negotiations among the social partners, encompassing wage determination, fiscal adjustment and major reform initiatives (for example in public pensions) within a mediumterm macroeconomic framework in line with EMU criteria.36 Fiscal discipline is a vital component of exchange rate stability, as confirmed by experiences with macroeconomic stabilization in a large number of advanced and developing countries, and more recently in the economies in transition.37 Among the latter the accession countries have learnt their lesson, as demonstrated by their attempts at fiscal consolidation. However, given the budgetary costs of restructuring tasks still pending, including those associated with EU single-market requirements and NATO membership, these countries are likely to suffer considerable fiscal stress over the medium term. In these circumstances no effort can be spared in containing fiscal imbalances and promoting convergence towards the EMU deficit and debt reference values. The good news is that anticipation of a durable fiscal adjustment, as part of the commitment to ERM-2, will lead to a significant decline in currency risk premia for the accession countries.38 The resulting fall in the interest burden should facilitate fiscal adjustment in countries with a large stock of public debt; on this score Hungary should be a major beneficiary. All the accession candidates are in the process of completing the tasks of postsocialist transition to qualify for the EU single market, including public administration reform, infrastructure investment, and enterprise and financial restructuring. Among these tasks, indispensable for exchange rate stability, has been the clean-up of non-performing portfolios in the banking system and the introduction and enforcement of effective prudential regulations and banking supervision standards. Past currency crises in Asia and the Czech Republic confirm the importance of vigilance in this area. In addition to making steady progress on the above fronts – namely increased wage flexibility, containment of fiscal imbalances and financial sector restructuring – each accession country will be able to acquire sufficient operational experience in managing a stable exchange rate regime by following a three-phase approach before formal entry into ERM-2. In the first phase, as experienced by many economies in transition, the exchange rate is needed as an anchor – be it in the form of a managed float or a preannounced or fixed rate – to cool inflationary pressures and confer policy credibility. To this end the nominal rate should be kept within relatively narrow implicit or explicit margins, while avoiding one-off devaluations. Thus the central bank

74 Exchange Rate Policy

should stand ready to intervene through market-based instruments (possibly the short-term interest rate). In the second phase (which has been reached by the leading candidates), having met the above conditions and achieved an adequate level of credibility the candidate country has latitude to widen the intervention margins substantially or even adopt a freely floating rate.39 A wide band or free float should help shift some exchange rate risk to potential speculators against the currency.40 In addition, increased exchange rate flexibility will facilitate inflation targeting to support eventual convergence with the EMU reference values for inflation and interest rates.41 In Poland the progressive widening of the nominal exchange rate band has proved useful for fending off the fallout from the Russian crisis, and – when followed by a free float – for paving the way for inflation targeting. Nevertheless large exchange rate fluctuations could lead to some erosion of credibility. In particular, during a period of turbulence in foreign exchange markets the accession countries should exercise caution and refrain from taking steps towards greater flexibility, be this through adoption of a wider band or exit from a currency board arrangement.42 In the final phase the accession countries should consider shadowing the euro as closely as possible (well within the ERM-2 margins), but without adhering to it at all costs.43 In order to preserve credibility the authorities could declare their commitment to the so-called restoration rule: undertaking to reinstate the former parity after a temporary deviation following a speculative attack.44 In general, having completed the fundamental tasks discussed above, the exchange rate will be subject to upward pressure from the long-term productivity bias, and more immediately from capital inflows in response to declining currency risk premia. Arguably, and despite its increasing appeal, unilateral euroization (that is, replacement of the domestic currency with the euro) may prove to be an unnecessarily restrictive and counterproductive course of action – especially in the absence of solid fundamentals – for these countries in the context of EU accession.45

Policy dilemmas While it might be unrealistic to formulate a precise timetable for formal entry into ERM-2 after EU accession, it is plausible that the leading candidates will be able to map out a convergence strategy over a medium-term horizon. As part of this strategy each country would endeavour to meet the key conditions for exchange rate stability: wage flexibility, fiscal and monetary discipline, and financial sector soundness. Having completed the bulk of these tasks and having gained sufficient credibility, the exchange rate of the candidate will shadow the euro, albeit with some flexibility, until formal participation in ERM-2. This convergence strategy, however, leads to two policy dilemmas that will ultimately have to be addressed jointly by the accession countries and

George Kopits 75

the other EU members. The root of the dilemmas is that, partly as a result of successfully tackling the above requirements, the exchange rate of each accession country will be subject to appreciation pressures owing to productivity bias and induced capital inflows. The first dilemma faced by the authorities involves the scope for exchange rate revaluation or for relaxation of a reference value; the second concerns the continued maintenance of capital controls. To alleviate upward pressure on the exchange rate at the time of EU accession, the candidate countries should attempt to narrow their productivity differentials vis-à-vis the EU average as rapidly as feasible by stepping up their restructuring efforts during the preaccession period. Yet no matter how swift the restructuring process and how large the concomitant productivity gains in the tradables sector, the productivity bias is likely to prevail well beyond accession; hence the dilemma.46 The solution to the problem of accommodating the appreciation pressure consists of allowing either for occasional (or continuous) upward realignments of the nominal exchange rate and/or for a higher inflation rate. Under the first option the accession country would be permitted to undertake occasional one-off revaluations – as occurred in the case of Ireland – prior to locking its exchange rate irrevocably to the euro in the final stage of EMU. Nominal appreciation above the central parity, even beyond the ERM-2 margin, would in fact be consistent with the Treaty of Maastricht.47 The second option would entail relaxation of the EMU reference value for the inflation rate, which is set at 1.5 percentage points above the average of the three best performers under EMU – a very stringent requirement for most accession countries. All in all it is likely that upward exchange-rate realignments would be more acceptable to the EU than a reinterpretation (or suspension) of the statute on reference values. The other dilemma, relating to capital controls, will require more immediate attention as for a while the accession countries may be vulnerable to excessive exchange rate volatility and sudden shifts in investor sentiment. In general the sequencing of external liberalization must be implemented prudently.48 It is widely recognized that current account convertibility, as well as the liberalization of direct investment and long-term, non-debtcreating capital flows, have been necessary for supporting market-oriented transformation. In addition outward flows should not remain restricted. However decontrol of debt-creating capital movements, especially shortterm inflows, should not proceed faster than domestic financial liberalization and the implementation of prudential regulations and banking supervision.49 Premature short-term capital account liberalization can impose a considerable burden on countries that attempt to adhere to (or announce the adoption of) a hard currency policy in that it may exacerbate the country’s exposure to speculative attacks, including contagion effects of currency crises elsewhere, unrelated to the country’s fundamentals. Therefore a case can be made for delaying short-term capital account liberalization

76 Exchange Rate Policy

until after EU accession, or at least for candidates that have not yet taken this step.50 Such a postponement would of course require approval by the EU – for example on the basis of the precedent set in connection with the enactment of the Single European Act of 1987.51

Summary and conclusions Although participation in EMU is not a formal requirement for EU membership, candidates for accession are expected to adopt the acquis communautaire of Stage 2 of EMU, including convergence towards the EMU reference values and adherence to the ERM-2, which was created for nonparticipant EU members. Thus it is useful to ascertain for the CEE candidates the desirability of adopting a hard-currency strategy and their ability to meet the conditions for entering ERM-2. For most of the leading accession candidates (the Czech Republic, Estonia, Hungary, Poland and Slovenia), given their small size, degree of integration (particularly concerning trade) with the EU and similarity in economic structure, the benefits (lower transaction costs, information costs and currency risk premium) are likely to outweigh the costs (mainly an inability to absorb asymmetric shocks) of joining ERM-2 and eventually the euro area. In any case, the potential net benefits derived from participating in EMU are likely to be larger for these countries than for some of the present non-core EU members. Furthermore, insofar as trade and cross-country correlations of output changes are endogenous to participation (or anticipated participation) in EMU, net gains can be expected to be positive and rising for all leading candidates over the medium term. A review of past exchange rate developments reveals that a dominant strength or weakness in terms of policy consistency in each accession country seems to have offset the effect of productivity gains in the tradables sector. In the past, while wage indexation has been a major shortcoming in Poland, and to a lesser degree in Slovenia, public sector deficits and indebtedness have been the principal sources of Hungary’s vulnerability, and insufficient financial and enterprise restructuring has rendered the Czech economy vulnerable to downward pressures on the exchange rate. Given weaknesses in fundamentals, the combination of a constrained exchange rate system and capital account openness has made some of these countries susceptible to speculative attacks following shifts in investor sentiment, as in the aftermath of the currency crises in Asia and Russia. By contrast Estonia has been characterized by flexible wage determination, fiscal discipline and a sound financial system. In sum, wage flexibility and a prudent fiscal and monetary stance, along with a sound financial system, are key conditions for successfully joining ERM-2. Having met these conditions, each accession candidate should be in a position to shadow the euro with some flexibility around the central rate while maintaining sufficient openness in the capital account. Overall the

George Kopits 77

leading accession countries have the ability to make steady progress in this direction and their present exchange rate regimes are compatible with convergence to ERM-2. There remain, however, two policy dilemmas that need to be addressed jointly by the accession countries and the present EU members. One involves the scope for exchange-rate revaluation or relaxation of the EMU reference value for inflation, and the other for postponement of full capital account liberalization as the accession countries will be subject to upward exchange rate pressures stemming from long-term productivity growth in the tradables sector and from capital inflows induced by successful reform and stabilization. Both dilemmas can be solved by the application (or reinterpretation) of relevant EU statutes and precedents. These implications are also broadly valid for less advanced CEE candidates that are on the verge of reaching a comparable stage in the development of market-based institutions and achieving sufficient macroeconomic stability. There is yet another group of economies in transition where, lacking these conditions, the exchange rate strategy must be selected by weighing more basic criteria: the need for a macroeconomic policy anchor on the one hand, and the need to accommodate deep structural transformation and maintain external competitiveness on the other. Notes 1. An earlier version of this chapter was presented at the Conference on Shaping the New Europe, Vienna Institute for International Economic Studies, 11–13 November 1998, and at seminars held at the Bank of Italy, National Bank of Hungary and the European Commission. Useful comments were received from conference and seminar participants and IMF colleagues, especially Peter Clark, Hans Flickenschild, Eduard Hochreiter and Gábor Oblath. Solita Wakefield provided statistical assistance and Zsolt Darvas provided the data for Figures 2.8, 2.9 and 2.10. The views expressed are those of the author and do not necessarily represent those of the International Monetary Fund. 2. The Copenhagen European Council of June 1993 declared that, in general, the applicant country must have ‘the ability to take on the obligations of membership, including adherence to the aims of political, economic and monetary union’. Subsequently, however, it was recognized that, ‘with respect to the aim of economic and monetary union, it is unlikely that the applicants will be able to join the euro area [Stage 3 of EMU] immediately upon accession’. See European Commission (1997), p. 57. 3. That is, including prohibition of direct central bank financing of public sector deficits, and privileged access to financial institutions. 4. For a recent review of the basic arguments for and qualifications of this assumption, see the essays in Blejer et al. (1997). See note 6 below for a brief summary of the empirical evidence. 5. See for example Sachs (1996). 6. Much empirical analysis, such as that in Bayoumi and Eichengreen (1993), based on historical correlations of output changes arising from demand and supply shocks among EU member countries and US regions, suggests that a number of

78 Exchange Rate Policy

7.

8. 9.

10.

11.

12.

13. 14.

15.

16.

17. 18.

EU members on the periphery (as compared with only a few outlying US regions) are prone to suffer destabilizing consequences from the loss of the exchange rate as a policy instrument upon joining the EMU currency area. For a recent review of similar evidence see Calmfors et al. (1997). However according to Canzoneri et al. (1996), past shocks that caused most output variations in the EU have not resulted in nominal exchange rate fluctuations, while the shocks that explained nominal exchange rate movements are monetary in nature. Overall the exchange rate seems to have acted as an asset price rather than a shock absorber. The upshot of this study was that EMU will not entail a significant cost in stability for participating EU member countries, with the possible exception of Italy. Such a situation could arise if, as a result of a downturn caused by recession in a major trading partner economy in transition, the candidate experiences a decline in output growth below its trend GDP without being entitled to a waiver (that is, with less than the threshold 2 per cent contraction) under the terms of the Stability and Growth Pact. Particularly, given the constraints on labour mobility due to the undeveloped housing market and inadequate mass transport. Estimates of the effect of asymmetric shocks (using alternatively GDP, industrial output and employment as dependent variables) on pooled panel data for the EU members and Slovenia (De Grauwe and Aksoy, 1997), indicate that Slovenia does not diverge from Germany, the benchmark country. This pattern is not surprising given the worldwide trend towards declining contributions, first on the part of agriculture and then of industry, to output and employment over the past few decades; see IMF (1997), ch. 3. It may be noted that all candidates have a more advanced and diverse economic structure than the CFA franc-zone member countries, which automatically participate in Stage 3 of EMU. The econometric evidence from a large panel of annual country data in a study by Frankel and Rose (1997), seems to rule out the hypothesis that increased trade integration can result in greater industry specialization by country and thus to asymmetric industry-specific supply shocks, as put forth in Krugman (1991). For discussions of the Czech case see Begg (1998) and OECD (1998). In the late 1990s trade-weighted average import tariff rates were estimated at 3 per cent in Hungary, 6 per cent in Poland and 11 per cent in Slovenia. Estimates of average effective rates of protection were 5 per cent for Hungary and 7 per cent for Slovenia. In Estonia the nominal and effective rates were near zero. Although difficult to quantify, non-tariff barriers have been lowered significantly in all the accession countries. For example in Hungary the average annual net cost of sterilization has been measured at nearly 0.2 per cent of GDP; see Szapary and Jakab (1998). On the effectiveness of sterilized interventions, IMF staff estimates of offset coefficients for the Czech Republic, Hungary and Poland range from ⫺0.4 to ⫺1. However application of the regime differed between the two countries. Unlike Hungary, Poland had resorted at an earlier juncture to several one-off exchange rate adjustments, and more recently it moved aggressively to reduce the rate of depreciation and widen the band. In 1992 and 1993 Poland undertook two oneoff devaluations that totalled 19 per cent, and in 1995 it revalued three times by a cumulative amount of 18 per cent. See Kopits (1995). See the analysis in Obstfeld and Rogoff (1996), ch. 4, the estimates for major industrial countries in MacDonald (1997) and those for South-East Asian countries in

George Kopits 79

19.

20.

21.

22.

23.

24. 25.

26. 27. 28.

Chinn (1998). Perhaps the best known corroborating case is that of postwar Japan: the appreciation of the yen (in real terms throughout the period, and in nominal terms since the mid 1970s, following the abandonment of fixed parities) can be largely explained by productivity gains in the tradables sector. Masson (1998) shows that the trend appreciation attributable to the productivity bias is roughly equivalent to the relative rate of technical progress in the tradables sector multiplied by the share of non-tradables in total output. For an attempt to measure this effect in transition economies see Halpern and Wyplosz (1997) and Krajnyak and Zettelmeyer (1998). For Hungary, Simon and Kovacs (1998) estimate a 3 per cent annual rate of appreciation in the long term. During the transition process major reforms in the fields of education, health care, pension systems, public administration, plus infrastructural investment in transportation, communications, environmental clean-up and protection, have combined to create conditions that are conducive to balanced productivity improvements across all sectors. See the distinction drawn between the opposite effects of economy-wide and tradables-based productivity increases in Krugman and Obstfeld (1997), p. 242. However the net effect of an overall increase in output on the nominal exchange rate is ambiguous and depends on whether the output increase raises the real transaction demand for money, thus pushing down domestic price levels in the long term. In each country wage negotiations take place under the auspices of a tripartite commission of social partners (comprising representatives of employers’ associations, organized labour and the government), which sets guidelines for maximum and/or minimum wage increments – usually on the basis of inflation forecasts – that are more or less binding on the private and public sectors. For government employees, wage adjustments are determined in the context of the budget. For the rest of the public sector and private enterprises, a rise beyond the level of inflation projected under the tripartite agreement can give rise to upward adjustment, even where decentralized bargaining is the dominant form of wage negotiation. For empirical evidence of the high degree of effective wage indexation in Poland (especially in the public sector), see Pujol and Griffiths (1998). Wage indexation has been less prevalent in Slovenia. For estimates of wage drift in Hungary see OECD (1997). In addition, explicit or implicit price indexation in some sectors (for example energy in Hungary) may have a similar effect to wage indexation. See the discussion and simulation results for Italy (allowing for risk aversion) and the United States (without uncertainty) by Clark and Laxton in IMF (1995, annex). Failure to capture this distinction explains the difficulty of estimating an empirically robust relationship between fiscal policy and exchange rate movements. Such a process was initially observed in Latin America; see Calvo et al. (1996) for the early experience of the CEECs. Second-order repercussions as the direct investment activity matures depend on the export creation, import substitution and profit repatriation associated with the initial investment. See the linkages between long- and short-term determination of the equilibrium exchange rate in MacDonald (1997). For an attempt to identify the reasons for and forms of contagion effects see Kaminsky and Reinhart (1998). Even under relatively stable conditions, price- and cost-based indicators of competitiveness are subject to a number of limiting assumptions (unchanged technology, demand structure and output mix) that are not likely to extend beyond the short term; see Lipschitz and McDonald (1992). The assumption underlying

80 Exchange Rate Policy

29. 30.

31. 32.

33.

34. 35. 36. 37.

38. 39.

40. 41.

42. 43.

44.

45.

46.

the ULC-based index, namely that other factor costs move in tandem with labour costs, is not overly restrictive; see Kopits (1982) for a comprehensive measure of unit factor costs. Other shortcomings include underlying statistical sampling problems and breaks in the series. In all the figures an upward (downward) movement of the exchange rate indicates appreciation (depreciation). Vulnerability was also apparent in the high and rising ratio of the stock of broad money (M2) to official foreign exchange reserves in 1996 (Table 2.3). The rationale for using this ratio as an indicator of vulnerability to financial crises is developed in Calvo (1998). The large stock of non-performing loans, including those inherited from the previous socialist regime, also reflect legal impediments to writing off such loans. By comparison it is interesting to observe that in Argentina, as expected under a currency board arrangement, inflation has remained equivalent to the rate (less than 2 per cent a year) in the anchor currency area. The impact of both crises was much stronger in Slovakia. Short-term interest rates jumped above 45 per cent and the exchange rate fell below the 7.5 per cent margin; the peg was abandoned at the end of October 1998. See the discussion of the experiences of Argentina, Chile and Uruguay with the preannounced crawling peg in McKinnon (1982). For an analysis of the Austrian experience see Hochreiter and Winckler (1995). For an evaluation of the effects of the concertazione see Fabiani et al. (1997). For the most part, high inflation and marked exchange rate depreciation in these economies have been induced by monetized fiscal expansion; see Fischer et al. (1996). See the evidence for Italy in Giorgianni (1997). Estonia shifted automatically from the Deutschmark to the euro as the anchor currency. Hungary and Poland substituted the euro for the European currencies in the initial basket, and later dropped the US dollar from the basket. See Helpman et al. (1994). On the compatibility of inflation targets with exchange rate bands in shockprone developing countries see Leiderman and Bufman (1996). For a theoretical analysis of inflation targeting in an open economy see Svensson (1997). See the discussion of exit strategies for countries seeking greater exchange rate flexibility in Eichengreen and Masson (1998). The central banks of countries participating in ERM-2 are not required to engage in automatic and unlimited intervention to defend the declared parity with the euro if this conflicts with the price stability objective. Introduction of this rule – implicit under the former gold standard and more recently followed by France during convergence towards EMU – along with temporary capital controls during such an episode has been advocated for the accession countries by McKinnon (1997). Euroization or dollarization without solid fundamentals can have adverse economic consequences, as experienced by Eastern Germany (in the context of German unification) and Ecuador, respectively. The opposite approach of slowing down the restructuring process for the sake of exchange rate and price stability (the approach apparently followed by the Czech Republic prior to the crisis in 1997) is highly counterproductive in that it simply delays the necessary relative price adjustments and fuels demand pressures, all of which eventually lead to an unsustainable external imbalance.

George Kopits 81 47. According to Article 109j of the Treaty, as part of the obligation to qualify for Stage 3 of EMU, EU members are required to observe ‘the nominal fluctuation margins provided for by the exchange rate mechanism of the EMS, for at least two years, without devaluing against the currency of any other Member State’. 48. See for example McKinnon (1982). 49. See the evaluation of various types of market-consistent capital controls in Eichengreen and Mussa (1998). For recent arguments in favour of capital controls see Bhagwati (1998). 50. After liberalizing capital flows it is very difficult to reimpose restrictions, except perhaps for a temporary period if this is justified by mitigating circumstances, such as excessive turbulence in foreign exchange markets due to contagion. 51. Completion of capital-account liberalization under the Act was postponed (with the possibility of further extensions) for Greece, Ireland, Portugal and Spain from July 1990 until January 1993. Moreover a safeguard clause permitted a member country that suffered monetary and exchange rate disturbances stemming from short-term capital movements to reimpose controls for a six-month period.

References Bayoumi, T. and B. Eichengreen (1993) ‘Shocking Aspects of European Monetary Integration’, in F. Torres and F. Giavazzi (eds), Adjustment and Growth in the European Union (New York: Cambridge University Press). Begg, D. (1998) ‘Pegging Out: Lessons from the Czech Exchange Rate Crisis’, CEPR Discussion Paper, no. 1956 (London: CEPR, September). Bhagwati, J. (1998) ‘The Capital Myth’, Foreign Affairs, May/June. Blejer, M., J. Frenkel, L. Leiderman and A. Razin (eds) (1997) Optimum Currency Areas: New Analytical and Policy Developments (Washington, DC: IMF), Calmfors, L., H. Flam, N. Gottfries, J. H. Matlary, M. Jerneck, R. Lindal, Ch. NordhBerntsson, E. Rabinowitz and A. Vredin [The Calmfors Commission] (1997) EMU – A Swedish Perspective (Dordrecht: Kluwer). Calvo, G. (1998) ‘The Unforgiving Market and the Tequilazo’, in J. M. Fanelli and R. Medhora (eds), Financial Reform in Developing Countries (New York: Macmillan). Calvo, G., R. Sahay and C. Vegh (1996) ‘Capital Flows in Central and Eastern Europe: Evidence and Policy Options’, in G. Calvo, M. Goldstein and E. Hochreiter (eds) Private Capital Flows to Emerging Markets After the Mexican Crisis (Washington, DC: Institute for International Economics), pp. 57–90. Canzoneri, M., J. Valles and J. Vinals (1996) ‘Do Exchange Rates Move to Address International Macro-economic Imbalances?’, CEPR Discussion Paper no. 1498 (London: CEPR, October). Chinn, M. D. (1998) ‘The Usual Suspects? Productivity and Demand Shocks and AsiaPacific Real Exchange Rates’, OeNB Working Paper 31 (Vienna: OeNB, 20 July). Cukierman, A., G. -P. Miller and B. Neyapti (2002) ‘Central Bank Reform, Liberalization and Inflation in Transition Economies – An International Perspective’, Journal of Monetary Economics, vol. 49, no. 2, pp. 237–64. De Grauwe, P. and Y. Aksoy (1997) ‘Slovenia and the European Optimum Currency Area’, Working Paper, ACE Project on Inclusion of Central European Countries in the European Monetary Union (Leuven, January). Eichengreen, B. and P. Masson (1998) Exit Strategies: Policy Options for Countries Seeking Greater Exchange Rate Flexibility, IMF Occasional Paper 168 (Washington, DC: IMF).

82 Exchange Rate Policy Eichengreen, B. and M. Mussa (1998) Capital Account Liberalization: Theoretical and Practical Aspects, IMF Occasional Paper 172 (Washington, DC: IMF). European Commission (1997) Agenda 2000: For a Stronger and Wider Union, vol. 1, DOC/97/6 (Strasbourg: European Commission, 15 July). Fabiani, S., A. Locarno, G. P. Oneto and P. Sestito (1997) ‘NAIRU, Incomes Policy, and Inflation’, Banca d’Italia Workshop on Monetary Policy, Price Stability, and the Structure of Goods and Labour Markets, Perugia, 27–8 June. Fischer, S., R. Sahay and C. Vegh (1996) ‘Stabilization and Growth in Transition Economies’, Journal of Economic Perspectives, Spring, pp. 45–66. Frankel, J. and A. Rose (1997) ‘Endogeneity of the Optimum Currency Area Criteria’, NBER Discussion Paper, no. 5700 (New York: NBER, August). Giorgianni, L. (1997) ‘Foreign Exchange Risk Premium: Does Fiscal Policy Matter? Evidence from Italian Data’, IMF Working Paper WP/97/39 (Washington, DC: IMF, March). Halpern, L. and C. Wyplosz (1997) ‘Equilibrium Exchange Rates in Transition Economies’, IMF Staff Papers (Washington, DC: IMF, December), pp. 405–29. Helpman, E., L. Leiderman and G. Bufman (1994) ‘A New Breed of Exchange Rate Bands: Chile, Israel, and Mexico’, Economic Policy, October, pp. 260–306. Hochreiter, E. and G. Winckler (1995) ‘The Advantages of Tying Austria’s Hands: The Success of the Hard Currency Strategy’, European Journal of Political Economy, vol. 11, pp. 83–111. International Monetary Fund (1995) World Economic Outlook (Washington, DC: IMF, October). Internation Monetory Fund (1997) World Economic Outlook (Washington, DC: IMF, May). Kaminsky, G. and C. Reinhart (1998) ‘On Crises, Contagion and Confusion’, unpublished Manuscript. Kopits, G. (1982) ‘Factor Prices in Industrial Countries’, IMF Staff Papers (Washington, DC: IMF, September), pp. 437–66. Kopits, C. (1995) ‘Hungary’s Preannounced Crawling Peg’, Acta Oeconomica, vols 3–4, pp. 267–86. Krajnyak, K. and J. Zettelmeyer (1998) ‘Competitiveness in Transition Economies: What Scope for Real Appreciation?’, IMF Staff Papers (Washington, DC: IMF, June), pp. 309–62. Krugman, P. (1991) Geography and Trade (Leuven: Leuven University Press). Krugman, P. and M. Obstfeld (1997) International Economics: Theory and Evidence (New York: Addison-Wesley). Leiderman, L. and G. Bufman (1996) ‘Searching for Nominal Anchors in Shock-Prone Economies in the 1990s: Inflation Targets and Exchange Rate Bands’, in R. Hausman and H. Reisen (eds), Securing Stability and Growth in Latin America (Paris: OECD). Lipschitz, L. and D. McDonald (1992) ‘Real Exchange Rates and Competitiveness: Clarification of Concepts and Some Measurements for Europe’, Empirica: Austrian Economic Papers, vol. 1, pp. 37–69. MacDonald, R. (1997) ‘What Determines Real Exchange Rates? The Long and Short of It’, IMF Working Paper WP/97/21 (Washington, DC: IMF, January). Masson, P. (1998) ‘Monetary and Exchange Rate Policy of Transition Economies After the Launch of EMU’, Fourth Dubrovnik Conference on Transition Economies, Dubrovnik, 24–6 June. McKinnon, R. (1982) ‘The Order of Economic Liberalization: Lessons from Argentina and Chile’, in K. Brunner and A. Metzler (eds), Economic Policy in a World of Change (Amsterdam: North-Holland), pp. 159–86.

George Kopits 83 McKinnon, R. (1997) ‘Towards Virtual Exchange Rate Stability in Western and Eastern Europe with or without EMU’, Working Paper no. 6 (Stanford, CA: Stanford University Center for Economic Policy Research, June). Obstfeld, M. and K. Rogoff (1996) Foundations of International Macro-economics (Cambridge, Mass.: MIT Press). Organization for Economic Cooperation and Development (1997) OECD Economic Surveys: Hungary (Paris: OECD). Organization for Economic Cooperation and Development (1998) OECD Economic Surveys: Czech Republic (Paris: OECD). Pujol, T. and M. Griffiths (1998) ‘Moderate Inflation in Poland: A Real Story’, in C. Cottarelli and G. Szapary (eds), Moderate Inflation: The Experience of Transition Economies (Washington, DC: IMF and National Bank of Hungary), pp. 197–229. Sachs, J. (1996) ‘Economic Transition and the Exchange Rate Regime’, American Economic Review, Papers and Proceedings, May, pp. 147–52. Simon, A. and M. Kovacs (1998) ‘Components of the Real Exchange Rate in Hungary’, NBH Working Paper, 1998/3 (Budapest: NBH, March). Svensson, L. (1997) ‘Open-Economy Inflation Targeting’, unpublished Manuscript. Szapary, G. and Z. Jakab (1998) ‘A csuszo leertekeles tapasztalatai Magyarorszagon’, Kozgazdasagi Szemle, October, pp. 877–905. Tamirisa, N. T. (1999) ‘Trade in Financial Services and Capital Movements’, IMF Working Paper, WP/99/89 (Washington, DC: IMF, July).

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Part II Sectoral Issues: Trade Policies, Competition Policy and Financial Sector Reform

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3 European Trade Policies: Clouds on the Horizon? Patrick A. Messerlin1

How will the European Union (EU) and the Central and East European countries (CEECs) interact in the current Doha round of negotiations in the World Trade Organization (WTO) and other international trade fora during the coming years?2 This question is of primary importance for the rest of the world because the EU has become a key trading partner, particularly as the United States is now less firm in its leadership and Japan is still hesitant about its global role. If it is clear that the EU influences the CEECs’ trade positions, it is equally clear that CEEC trade policies will influence EU trade strategy. As argued below, this second factor may be crucial, and all the more so because many vital trade issues in the years to come, such as services and government procurement, will be under the joint competence of the EU and its member states, opening up increasingly wide channels of reciprocal influence between the countries of Western and Central Europe. Of course the question is also of primary importance to the EU itself. To date the EU has had a fairly good idea of the trade agendas of its future member states, which explains why the United Kingdom and Denmark had to wait so long to join. When granting accession to Austria, Finland and Sweden the EU was clearly aware that the trade policies pursued by these new member states would push it towards a more open approach (with the exception of agriculture, where the acquis communautaire was so well entrenched that it could not be influenced by more liberal new member states such as Sweden). Indeed this has proved to be the case, as illustrated by Sweden’s efforts to open up the EU textile and clothing markets and Austria’s votes on a series of antidumping cases relating to bleached cotton. Things may have been less clear where the accession of Greece, Portugal and Spain was concerned, but the three accessions were spread over almost a decade. By contrast the CEECs represent an extended series of accessions by countries whose trade policy doctrines are unknown, as emphasized below. Moreover as the current EU-15 probably constitute the most free-tradeoriented community since the very first days of the EEC, it is particularly important for the free-trade camp to be better informed about the CEECs’ 87

88 European Trade Policies

trade agenda. The question is whether or not the EU-25 will represent the peak of a free trade-oriented community. The answer to this question could govern many of the decisions taken prior to accession. This question is also of primary importance to the CEECs, and in this respect their current trade policies are paradoxical. On the one hand these policies seem to have stabilized – in sharp contrast to the rocky days of the early 1990s when the CEECs shifted from extreme protection and artificial openness under Soviet rule to unilateral, non-discriminatory trade liberalization under market rule, followed in most cases by bilateral trade agreements with the EU combined with increased protection vis-à-vis the rest of the world. On the other hand almost all the CEECs still seem unable to define their preferred trade policy in domestic terms. It would seem they have difficulty, defining their own doctrine and agenda in trade matters, the degree to which they would like to be open or protected, and the form the progressive liberalization of services should take at the global level. As a result it is difficult to predict how they will vote in the European Council (once they become member states) on major trade issues that face the EU in WTO fora and elsewhere. The CEECs’ lack of doctrine could be explained by transitory circumstances. It could also be related to more stable factors, such as these countries’ trade structures. Once they have joined the EU a very large portion of their trade will be intra-EU trade. As a result they may be obliged to focus on the acquis communautaire (EU domestic laws) and so neglect the extra-EU component of their trade, but ultimately they will have to develop their own doctrine on this. That notwithstanding, the weight of extra-EU trade in their GDP is likely to increase in the long term, as it did in France and Spain, which displayed a higher degree of protection than the EU average when they joined the Community. In other words there will be an increasing need for the CEECs to draw up their own trade policy doctrine. Far from relieving them of this task, becoming EU member states will make it all the more necessary for them to address it. This chapter examines the key reasons for the absence of a clear trade doctrine among the CEECs and reviews likely EU–CEEC interactions on trade matters in multilateral fora in the years to come. For the sake of simplicity the chapter is based on a taxonomy of all CEECs divided into three ‘waves’ in a strict trade policy context: (1) former Czechoslovakia, Hungary and Poland, (2) Bulgaria, Romania and Slovenia, and (3) the three Baltic states.3 The first section looks at the past: it shows that the first CEEC moves towards trade liberalization – based on a non-discriminatory approach – were much more beneficial on both economic and political grounds than is usually claimed. The second section considers the emerging economic costs of the current CEEC trade regime, which is dominated by the Europe Agreements, and the third section looks at the cost variances between the EU and the CEECs and the difficulty of managing that asymmetry. The fourth section

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examines the political benefits that balance the economic costs and the fifth section enlarges the perspective by introducing inter-CEEC relations with the CEFTA countries. Finally, the sixth section focuses on future relations between the EU and the CEECs in the WTO forum.

European trade policies in the early 1990s Almost immediately after the fall of the Berlin Wall the first wave of CEECs engaged in unilateral trade liberalization based on the non-discriminatory, ‘most favoured nation’ (MFN) principle. This brought rapid and enormous economic benefits. The CEECs’ trade patterns changed dramatically within a couple of years: EU–CEEC trade boomed, intra-CEEC trade collapsed and trade between the CEECs and non-EU/non-CEEC countries declined. The two first changes reflect a return to trade flows based on comparative advantage (Kaminski et al., 1996; Hoekman and Djankov, 1997). Transaction costs associated with the suddenness of economic and political change in Central Europe (and the short duration of most CEEC unilateral trade liberalizations) are the most likely explanation for the decline in the CEECs’ trade with non-EU countries. More importantly the non-discriminatory approach also brought major political benefits to the CEECs that were unanticipated at the time and are still often unrecognized today. These gains stemmed from the fact that between 1989 and 1991 the unilateral trade liberalization conducted by the first wave of CEECs convinced an initially reluctant EU to liberalize its own trade policy in respect of the CEECs. In fact the CEECs’ shift in trade policy more or less forced the EU to include Hungary and Poland (already under MFN treatment) in its Generalized System of Preferences for a period of five years, to eliminate all its quantitative restrictions on Hungarian and Polish exports for a year (except for a long list of ‘sensitive’ products), to grant the same benefits to Czechoslovakia in 1991 and to extend all these measures progressively to the other CEECs.4 The two first waves of CEEC non-discriminatory liberalization lasted less than two years, and one after the other the CEECs switched to bilateral and discriminatory trade agreements with the EU through the so-called Europe Agreements. By contrast the Baltic countries have retained their zero (Estonia) or low tariff schedules (Latvia and Lithuania) to this day, apart from a few exceptions, such as the possibility of imposing transitory tariffs on farm products in Estonia without parliamentary approval and the possibility of imposing restrictive regulations on audiovisuals in Latvia. The discriminatory approach based on the Europe Agreements induced all the CEECs in the first and second waves (except the Czech and Slovak Republics, for reasons explained below) to increase their protection with respect to non-EU countries. The relationship between the Europe Agreements and the increase in CEEC protection towards non-EU countries

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was causal – not coincidental. The CEECs in question set their current non-EU tariffs either during the last year of the Uruguay Round negotiations (1993 for Poland, Hungary and Romania) or even later during their accession negotiations (Bulgaria or Slovenia) – that is, after signing the Europe Agreements.5 Emphasizing this causality is not intended as a means of revealing the ‘villains’ of the piece; rather it is essential to understanding what is happening now (the emergence of economic costs for the CEECs from the Europe Agreements) and what might happen in the future. The capacity of the CEECs to increase protection has been facilitated by the fact that the Europe Agreements are purely bilateral agreements between each individual CEEC and the EU (the so-called ‘hub and spokes’ arrangement); they do not constitute a regional trade agreement.

Emerging economic costs to the CEECs The relative degree of harmony or acrimony in trade relations between the CEECs and the EU during the coming decade will be determined by the balance of costs and benefits that the Europe Agreements bring for each CEEC. In turn this balance will largely be determined by the MFN trade policy of the CEECs: the substantial rise in CEEC protection on imports from non-EU countries (following signature of the Europe Agreement) has increased the value of the preferences that each CEEC has granted to EU producers – sometimes to an enormous extent. These changes are best illustrated by Poland and the Czech Republic (Figure 3.1). At one end of the spectrum, Poland has shifted without too many constraints from non-discriminatory, unilateral liberalization to a discriminatory policy with severe protection with regard to non-EU countries: the average Polish tariff increased from 5.5 per cent in 1991 to 18 per cent in 1992, and then stabilized at around 15 per cent in 1995. The Czech Republic (and to a much lesser extent Slovakia) stands at the other end of the CEEC spectrum: its strong GATT/WTO anchor (particularly its obligation to follow the GATT/WTO rules on bound tariffs) has prevented it from increasing its tariff protection by more than one percentage point (using more complex instruments, such as surcharges, proved too difficult to implement in an effective manner). As emphasized by Bhagwati and Panagariya (1996), economic benefits and costs in cases of discriminatory trade agreements follow the mercantilist logic, where benefits come from exports and costs from imports: [A] country benefits from receiving a discriminatory access to the partner’s market and is hurt by giving the partner a similar access to its own market. When the country gives access to the partner on a preferential basis, it loses the tariff revenue collected on imports from the partner. The revenue goes to boost the terms of trade of the latter. The reverse

91 Czech Republic 7 6 5 4 3 2 1 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Poland

20 18 16 14 12 10 8 6 4 2 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 EU 8 7 6 5 4 3 2 1 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 MFN tariffs

EA tariffs

Figure 3.1 MFN and Europe Agreement tariffs, Czech Republic, Poland and EU, 1991–2000

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happens when a country receives a preferential access from the partner. (Panagariya, 1996, p. 486) In other words the economic benefits from the Europe Agreements accruing to the CEECs should flow from the additional preferential access to EU markets that CEEC products enjoy. However, as the CEECs were already enjoying broad access to the EU markets for all products (except in sensitive sectors) before the Europe Agreements, the latter have not actually provided additional gains of any substance. Another source of economic gains could be derived from economies of scale. In the case of the CEECs, however, this argument is weak: the CEEC economies are relatively small, and most CEEC producers could easily enjoy the benefits of scale economies in world markets even if their access to EU markets were imperfect. If the CEECs were to enjoy major additional gains, the EU would have to open up its sensitive sectors (agriculture, steel and clothing). This, however, has not occurred and the very fact that these sectors constitute key WTO issues makes any noticeable progress outside the WTO forum unlikely. Meanwhile the economic costs imposed by the Europe Agreements on the CEECs originate with imports: the major import flows from the EU that were already taking place before the Europe Agreements were signed. In terms of tariff elimination, the ‘asymmetry’ provision in those agreements implies that the CEECs only really entered into the Europe Agreements (that is, began substantially to reduce their tariffs on EU goods) in 1996. As is well known, the discriminatory elements in the Europe Agreements trigger two opposite effects when a CEEC that is incapable of producing goods in an efficient manner decides to purchase those goods from the EU: the country’s welfare is increased (the trade creation effect) if the EU is an efficient world producer of the goods; or the country’s welfare is reduced (the trade diversion effect) if the EU is an inefficient producer, by world standards, of the goods in demand (when the CEEC purchases the products in question from the EU solely because the elimination of CEEC tariffs on EU exports gives the EU producers a price advantage over producers from countries that are not signatories to the Europe Agreements). The net impact of these opposite forces depends on two parameters. First, the question arises as to whether instances of costly trade diversion are more frequent than those of profitable trade creation. The usual answer to this question is that the EU is a large and open economy and therefore should be an efficient one.6 This answer is highly debatable. If non-tariff barriers (NTBs), antidumping duties or voluntary export restraints (VERs) are taken into account, a substantial number of EU industries can be seen as benefiting from substantial protection: in 1995 only six EU manufacturing sectors (out of a total of 41) were granted an unweighted average tariff that was higher than 10 per cent, while 16 others were granted an unweighted

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average border protection (tariffs and other barriers) that was higher than 10 per cent (Messerlin, 1999). Second, the question arises as to the potential costs of these trade diversion cases. As emphasized by Bhagwati and Panagariya (1996), the more that CEECs import from the EU, the higher the trade diversion costs are likely to be. If the CEECs reduced their tariffs on EU goods for which there were no efficient EU producers, they would still gain from the fact that the EU producers would supply these goods at lower prices than those which Central European producers would have charged. That notwithstanding, the CEECs would lose out on the difference between EU and world prices: it would be preferable for them to buy the goods from the rest of the world and keep for themselves the difference between the EU and world prices, including tariff revenues. Such CEEC losses are the EU producers’ gains. The very fact that the EU is the source of some 60 per cent of CEEC imports suggests huge transfers from relatively poor CEEC consumers to inefficient EU producers.

‘Asymmetry’: shifting sides The Europe Agreements have been much praised for their ‘asymmetrical’ nature, which refers to the fact that EU tariffs on Central European products are being eliminated more rapidly than Central European tariffs on EU goods. This asymmetric timing of trade barrier elimination, however, masks another asymmetry – one that has a much more important bearing for the future – in terms of the net costs of the Europe Agreements to the CEECs. The EU will face declining and relatively small costs whereas the CEECs in the first and second waves will face increasing and relatively much greater costs as a result of the Europe Agreements. Evolutionary forces in the EU are the same as those in the CEECs: for the CEECs this means that the volume of preferences granted by the EU to individual CEECs will be determined by their own trade policies towards non-CEECs, as compared with the additional preferences granted to the CEECs. In the Europe Agreements the EU has granted very limited additional preferences to the CEECs (in sharp contrast to the generous CEEC preferences to the EU, as will be shown below). Fundamentally the EU has only made permanent those concessions which had already been granted on a transitory basis. EU duties imposed on Central European exports were already low in the period after 1991 because the CEECs had become eligible for the EU general system of preferences. Most of the EU non-tariff barriers were eliminated in 1991–92 on an annual basis. Making these concessions permanent cost the EU little, all the more so because it simply duplicated its commitments under the Uruguay agreement on safeguards (excluding agriculture and steel).7 As a result, most of the additional concessions under the Europe Agreements consisted of ‘outward processing traffic’ (OPT) quotas in

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textiles and clothing, plus complete elimination of all the quotas by 1998. However OPT quotas could be used exclusively for goods produced in the CEECs from raw materials or intermediate goods imported from the EU, which gave EU firms strong leverage over CEEC firms during the period when they were preparing for the complete elimination of non-trade barriers (January 1998). As a result the exact value of these preferences during the transition period and thereafter is debatable.8 Finally, with regard to contingent protection the CEECs not only failed to secure EU preferential antidumping rules in respect of their exports, but under the Europe Agreements they became subject to rules that were even less satisfactory than the disciplines provided for under the WTO Code of Safeguards: European Agreement safeguards can be invoked in circumstances that do not exist in the WTO framework, such as in the case of ‘serious disturbance’. In fact between 1990 and 1997 CEECs were accused of 25 cases of dumping (as many as before 1989), particularly in the steel sector, thus making largely illusory the EU’s concessions in this sector. Moreover the EU’s Uruguay Round commitments with regard to nonCEEC countries, the 1996 Singapore Information Technology Agreement (covering goods that CEECs could produce) and the Euro-Med Agreements with Mediterranean countries have all served to erode the small additional preferences that the EU granted to the CEECs in the Europe Agreements. Figure 3.2 summarizes the above arguments by showing the time pattern of the ‘preferential average concession’ (defined as the difference between preferential and MFN tariffs). It illustrates the evolution of EU and CEEC concessions between 1991 and 2001.9 After peaking in 1996–97, the preferential average concession granted by the EU to the CEECs declined over

14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Czech Republic

Poland

EU

Figure 3.2 Preferential average concessions, Czech Republic, Poland and EU, 1991–2000

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time, whereas the preferential average concession granted by the CEECs to the EU increased after 1996–97. It is hard to believe that this divergence will aid EU–CEEC (and intra-CEEC) trade relations in the near future or create an environment favourable to free trade in the CEECs.

The political benefits and costs of the Europe Agreements The approach adopted above for assessing the costs and benefits accruing from the Europe Agreements ignores political aspects. If political dimensions constitute a legitimate concern their impact should not be understated: in order to be carried out successfully a political decision needs the approval of a majority of voters. If the economic costs of a given political decision are too high, support for it is likely to vanish. In other words, what has been said above about the economic costs of the Europe Agreements is relevant to assessing the political factors to be considered in this section. For simplicity’s sake, political considerations can be divided into three main categories (de Melo and Panagariya, 1992; Fernandez, 1997): security, credibility and insurance.10 An extensive discussion of the political gains related to security, defined as the CEECs’ desire for permanent independence from the former Soviet Union and a strong defence against Russia, is beyond the scope of this chapter. However it is difficult to see how the Europe Agreements could enhance the political situation of the CEECs vis-à-vis the Soviet Union. In the early 1990s many Central Europeans perceived the Soviet retreat from Central Europe as temporary and were afraid of a comeback. Were the Europe Agreements an appropriate answer? Almost certainly not. This is because, despite the minute impact on the huge EU economy that economic competition from Central Europe was expected to have, in the Europe Agreements the EU showed no willingness to compromise on agriculture, steel, clothing and a few other sensitive sectors. This could hardly serve to reassure the Central Europeans that the West Europeans were ready to fight for them. And it could hardly have been better news for those Soviet generals who were eager to return to Central Europe. The Europe Agreements are also often perceived to be an instrument of credibility for the CEECs’ economic transition and reforms. This perception is based on the assumption that a commitment is more credible if it is made by one preferred trading partner (the EU) than if it is made by a group of trading partners (such as the United States, Japan and the EU) that might include the preferred partner. This argument is convincing only if the preferred trading partner has more effective means of monitoring the countries in question and taking retaliatory action against them than an alternative group of trading partners. If this is not the case (and why should it be?) it is hard to see why fewer anchors offer a better alternative than more anchors. In the case of trade issues, this view is reinforced by the post-Uruguay strengthening of the WTO dispute settlement mechanism, which offers a

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choice between quasitrade tribunals (panels) and bilateral or plurilateral consultations (negotiations). Finally, the argument that the Europe Agreements constitute insurance against EU practices that could be harmful to CEEC interests has already been examined above, mostly in connection with the protection of quotas (such as antidumping actions), which is likely to be the most worrisome source of harmful EU decisions. That this argument is often presented under a political heading raises a basic question that is in keeping with the tradition of realpolitik: how can a bilateral and asymmetric agreement (in terms of the two parties’ respective powers) give the weaker signatory firmer guarantees than a multilateral agreement? Indeed the WTO regime, with its dispute settlement mechanism, offers the CEECs something that the Europe Agreements do not provide: if necessary the CEECs can challenge EU practices in the WTO framework – an option that is unavailable to them under the ‘hub and spokes’ regime of the Europe Agreements. These observations combine to suggest that the Europe Agreements are economically and politically costly to the CEECs. This troubling conclusion raises the question of why the CEECs signed the Europe Agreements. A possible answer is that in the chaotic political environment, that prevailed in Central Europe in the 1990s, politicians were inclined to adopt a course of action that offered almost instant benefits (such as press headlines on or TV coverage of negotiations on accession to the EU) and postponed costs (hence the focus on the legal asymmetry of tariff reductions and the failure to recognize their costs), in contrast with MFN trade agreements, which would have imposed costs in the short term (immediate economic adjustments would have to have been made because immediate concessions would have been granted to the rest of the world) and provided benefits mostly in the long term.

The CEFTA conundrum In 1991, almost a year before the Europe Agreements came into effect, Czechoslovakia, Hungary and Poland signed the Central European Free Trade Agreement (CEFTA). This took effect in March 1993, almost a year after the implementation of the interim Europe Agreements. The time lag between the two events reveals two different rationales behind CEFTA. Its initial purpose was to limit the collapse of trade between the CEECs following the termination of the Council for Mutual Economic Assistance; after 1992–93, however, its purpose was more to reduce the negative consequences on the CEECs of the ‘hub and spokes’ regime generated by the Europe Agreements, as well as to contribute to the ultimate objective of joining the EU. This twist in its rationale explains why CEFTA is unlikely to conform to crucial WTO requirements connected to the regional trade agreements laid down in Article 24 of GATT and in the Uruguay Round

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understanding on its interpretation. In particular it does not cover all the trade between partners because agriculture and several sensitive industrial sectors have been excluded. Despite these many problems, other CEECs are progressively joining CEFTA, so is CEFTA likely to become a melting pot where CEECs can define their own trade agenda and doctrine for the forthcoming WTO negotiations?11 At present CEFTA is probably one of the best illustrations of the ‘spaghetti bowl’ that Bhagwati (1993) foresaw in the drift towards discriminatory trade agreements; it is not a single trade agreement, but a set of bilateral trade agreements between CEEC members. As a result it has exacerbated discrimination during the transition period, since for any given product each CEEC has not liberalized at the same pace as every CEFTA partner. Moreover the signatories are free to determine their own MFN rates with respect to third countries. The decision to allow this freedom may have been governed by political motives beyond the scope of this chapter, but it was certainly a consequence of the fact that, because of the very large differences in terms of MFN protection between the CEECs vis-à-vis non-EU countries, agreeing on a common Central European external tariff would have been difficult (Economic Commission for Europe, 1996).12 The first years of CEFTA were rocky, and initial intra-CEFTA liberalizations were rapidly followed by protectionist measures. Between 1995 and 1997 almost all the CEFTA countries imposed import surcharges (from 5–10 per cent, depending on the CEFTA member) on a range of products, including alcoholic beverages, tobacco products, fuels and cars. Moreover the CEFTA rules permit temporary increases in customs duties under the structural adjustment clause, a provision that the CEFTA members have not hesitated to use. Interestingly, quota protection – in the form of safeguard measures – has been implemented more often and more strictly on imports from CEFTA partners than on imports of similar products from the EU. In fact many of the earlier trade disputes between CEFTA members and the EU have reemerged in the bilateral CEFTA context. For instance in 1995 Hungary decided to prohibit imports of used cars for four years, thus echoing the segmentation of the Central European markets under the provisions on cars in the Europe Agreements.13 More recently the Hungarian and Slovak authorities have been more vocal about the loss of fiscal revenues as a result of intra-CEEC trade liberalization than they have been about the much larger losses caused by the Europe Agreements. Leaving these difficulties aside, it is important to emphasize the following economic fact: a discriminatory trade agreement between two small countries that also trade with a third large country (a typical situation for two of the CEFTA members associated with the EU) harms the small importing country whenever imports from the large country are required to clear the market of the small importing country. In a situation such as this, prices in the small importing country remain unchanged (they are determined by the

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export prices set by the large country plus the tariff), as does the welfare of the domestic consumers. However the government of that country loses tariff revenues, which become either additional surpluses for domestic producers or deadweight losses wasted by those producers. The small net importing country thus loses out, as does the free-trade area as a whole, despite the fact that the small exporting country could be a net beneficiary. Moreover as the CEFTA countries differ substantially in terms of MFN protection (a high MFN tariff in one country can be a low MFN tariff in another), the net gains flowing from the elimination of producers behind the high MFN tariffs by producers behind the low MFN tariffs depend on the capacity of the most efficient producers to supply the initially highly protected country. In turn this depends on the likelihood of direct or indirect trade deflection. Direct trade deflection (goods first enter the country with the lowest MFN tariffs, and only later the countries with the highest MFN tariffs) is limited by rules of origin, or in cases where the enforcement of customs regulations is lax, by bribery costs. By contrast indirect trade deflection (goods enter the country with initially low tariffs in order to replace domestically produced goods sold in the country with initially high tariffs) is beyond the reach of rules of origin. It can, however, occur if there is enough excess productive capacity in the low-tariff country. Moreover as it offers exporters opportunities to adopt monopolistic behaviour, it does not necessarily lead to large gains for consumers located in the country with the highest tariffs. These two factors are likely to play a major role in the bilateral trade agreements entered into by the CEECs – as shown by EU history, price differences, even between members of a customs union, can remain extremely high for decades. Finally it is important to emphasize that a concrete solution to many of the problems raised by the Europe Agreements and CEFTA does not require complex negotiations or new institutions. It would be sufficient for the CEECs (preferably jointly) to reduce the differences between their own MFN tariffs and the corresponding EU MFN tariffs over a given period. This initiative, which should only cover Central European MFN tariffs that were higher than the EU tariffs, would bring economic gains to the CEECs – and to the EU as well if CEEC accession to the EU reduced the highest EU tariffs or NTBs. This MFN-based initiative would also yield major political gains for the CEECs: it could shorten the time taken to accede to the EU; and since a more open MFN trade policy is a good substitute for many policies in the case of small economies, an initiative of this kind would accelerate the transition process.

European trade policy in the coming years The coming decade will be dominated by two interacting sets of issues. First, the enlargement of the EU will lead to the largest ever consolidation of preferential trade agreements (PTAs) since the creation of GATT in 1947. In 2001 the PTAs in force between the EU, the CEECs (plus the EFTA countries,

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Turkey and so on) accounted for almost half of the 141 PTAs notified to the WTO.14 The large-scale consolidation of these European PTAs will restore WTO supremacy in a very significant way. It is important to note that this evolution is a tribute to the WTO because successive GATT rounds have profoundly contributed to intra-EC liberalization by inducing the EU to lower its MFN and internal tariffs, hence reducing the risk and magnitude of PTArelated inefficiency costs for EU member states. Second, these PTAs will not all disappear at once, especially because the timing of all CEEC accessions to the EU is not yet clear, and the Doha Round may be concluded before certain accessions. The present EU trade policy in goods is almost fully ‘communitarized’, meaning that not only tariffs but also NTBs, such as quotas, are defined at the EU level. However it is hard to tell whether the EU quotas are mere aggregates of individual member state’s quotas (as in fisheries) or whether they are genuinely defined at the EU level. Knowledge of this would provide a better sense of how CEEC NTBs will be integrated into the trade regime of the enlarged EU, and the extent to which they will perpetuate the CEEC preaccession protection pattern. Looking at the current market openness of the CEECs in goods, more CEECs (including the largest ones) can be expected to join the non-liberal camp of the EU than to join its liberal camp, whereas the relative size of the EU-15 and the CEECs will make compensation imposed by CEEC reprotection affordable for the EU. As a result, while refocusing the EU’s attention on market access issues, the consolidation of European PTAs is unlikely to lead to the EU being more forthcoming in the Doha negotiations. Difficulties are likely to be greatest in CEEC sectors with huge, yet unresolved problems (steel, clothing, agriculture and so on), which will nurture increasing tension between the EU and emerging or developing countries, which are often perceived by CEECs as close competitors. Moreover the CEECs may use antidumping and similar instruments of protection to erode ex post the liberalizations they cannot block during the Doha Round. A difficult situation is also likely to emerge in services, where protection is still high and is largely based on member states’ regulations and granted through opaque instruments. Hence there are wide gaps between the most and least protectionist member states, and the CEECs and the EU could be subject to large compensation claims. Indeed this has been clearly illustrated by the Baltic countries’ accession to the WTO. These countries have found themselves squeezed between the EU and the United States with respect to their future GATT commitments for audiovisuals. In order to please the most protectionist EU member states (such as Belgium and France) and to avoid any risk of paying compensation, the Baltic countries have chosen to align their commitments to the EU’s lowest common (highest protectionist) denominator on audiovisuals. One solution to these issues would be for the CEECs to draw up a robust doctrine on trade policy. In the absence of such a doctrine they will be

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inclined to freeload in line with the most protectionist EU member states and to trade short-term gains in negotiations against long-term economic losses, to their own detriment and that of the EU. Notes 1. I would like to thank all the participants at the WIIW Anniversary Conference for their very helpful comments, in particular Danuta Hübner and Erik Berglöf. 2. In this chapter Central Europe refers to the 16 countries located between the EU and the Eastern European countries of Russia, Belarus and Ukraine. However the discussion only covers ten countries: Estonia, Lithuania, Latvia, Poland, the Czech Republic, Slovakia, Slovenia, Hungary, Romania and Bulgaria. The six other countries – Croatia, Serbia, Bosnia-Herzegovina, the former Yugoslav Republic of Macedonia, Albania and the Republic of Moldova – are so absorbed in stabilizing their external borders or their domestic institutions that their cases are not pertinent to the discussion. 3. Of course the degree of liberalization was different for each wave: it was high and relatively transparent only for the first and third waves. For more details see Messerlin (2001). 4. Hungary provides the best illustration of the economic benefits to be had from convincing the EU to react: Hungarian exports, which had stagnated for a year after the cooperation agreement, increased dramatically within three months of the EU’s responses to the first wave of CEEC trade liberalization. 5. The Estonian customs law mentioned above may be the first sign that increased protection would accompany the Europe Agreement between the EU and Estonia. Indeed the fact that the EU decided to include Estonia in the first group of potential accession candidates is rather intriguing, particularly given the EU’s condition that upon accession new members will have to terminate any preferential agreements they have with third countries. 6. It could also be argued that a discriminatory trade agreement may be more tradecreating if it includes a member with high MFN tariffs – this because it is more likely to eliminate the industry of the least efficient member. To the extent that the CEECs have been high-tariff countries since their reprotection as MFNs, this argument could be applied to them. But it would be somewhat awkward to do so as they increased their MFN protection on an ex post basis, that is, after signing the Europe Agreements. It seems inappropriate to praise the Europe Agreements for reducing ex post the costs of CEEC tariff increases that the same agreements contributed to ex ante. 7. Indeed one could argue that the EU was able to sign the Uruguay Agreement on Safeguards because it had already scrapped its NTBs against the CEECs, which were by far the most numerous. NTBs against market economies, particularly Asian economies, were already in the process of being ‘translated’ into antidumping cases. 8. The OPT provisions may have been useful in that they gave CEEC producers an easy start by ‘integrating’ them, so to speak, with West European firms. But they could become either a binding constraint if CEEC producers are efficient, or an empty shell if they are not. According to Pellegrin (2001), trade volume under the OPT clause has been significant only in the case of Czech firms, whereas it has steadily declined in all other CEECs. 9. Figure 3.2 is based on the following simplifying assumptions: annual constant tariff decreases and no consideration of sensitive sectors and other discriminatory

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10.

11.

12.

13.

14.

trade agreements signed by the EU and the CEECs. Whereas on average the CEECs have six to seven discriminatory agreements, the EU has contractual and reciprocal agreements with 26 countries (including the CEECs), contractual but non-reciprocal agreements with 70 countries (the Lomé Convention) and non-contractual and non-reciprocal agreements with roughly 100 countries (the GSP). All this creates much more uncertainty about the real economic value of EU preferences than the preferential agreements that the CEECs have been able to secure. For a lively debate see Baldwin et al. (1997) and the discussion accompanying their paper. See also Panagariya (1996, p. 499) for an illustration of the causality issue in the NAFTA case. There is also an agreement (the Baltic Free Trade Agreement) between Estonia, Latvia and Lithuania. Its fate is more a political than an economic issue. The agreement has been in effect since April 1994 and is ultimately aimed at setting up a customs union. It covers almost all manufactured goods, and it has been supplemented by the Trade Agreement in Agricultural Products (signed in 1996), which extends trade liberalization to farm products. The exception of the Czech and Slovak customs union is more apparent than real: the frequent use of surcharges on top of tariffs have transformed this customs union into a de facto free trade agreement. As well as indirectly echoing the EU–Japan agreement. The Europe Agreements provide for Central European quotas on EU cars – the best example being the Polish quota. These provisions have de facto granted one or two EU car makers a privileged position in the Central European markets. However under the Stability Pact initiative the Balkan countries (including Bulgaria and Romania) have been induced to sign preferential bilateral trade agreements between themselves, creating 21 new bilateral agreements that it is hoped will be subject to a consolidation process, leading to an integrated Balkan economic space with a very open multilateral policy.

References Baldwin, Richard, Joseph Francois and Richard Portes (1997) ‘The Costs and Benefits of Eastern Enlargement: the Impact on the EU and Central Europe’, Economic Policy, vol. 24 (April), pp. 127–76. Bhagwati, Jagdish (1993) ‘Regionalism and Multilateralism: An Overview’, in J. de Melo and A. Panagariya (eds), New Dimensions in Regional Integration (Cambridge: Cambridge University Press). Bhagwati, Jagdish and Arvind Panagariya (1996) Preferential Trading Areas and Multilateralism: Strangers, Friends or Foes? (Washington, DC: American Enterprise Institute). De Melo, Jaime and Arvind Panagariya (eds) (1992) New Dimensions in Regional Integration (Cambridge: Cambridge University Press). Economic Commission for Europe (1996) ‘The Re-emergence of Trade among the East European and Baltic Countries: Commercial and Other Policy Issues’, Economic Bulletin for Europe, vol. 48, pp. 75–92. Fernández, Raquel (1997) ‘Returns to Regionalism: An Evaluation of the Nontraditional Gains from Regional Trade Agreements’, World Bank Policy Research Working Paper no. 1816 (Washington, DC: World Bank, August). Hoekman, Bernard and Simeon Djankov (1997) ‘Determinants of the Export Structure of Countries in Central and Eastern Europe’, World Bank Economic Review, vol. 11, pp. 471–87.

102 European Trade Policies Kaminski, Bartlomiej, Zhen Kun Wang and L. Alan Winters (1996) ‘Export Performance in Transition Economies’, Economic Policy, October, pp. 423–42. Messerlin, Patrick A. (2001) Measuring the Costs of Protection in Europe – European Commercial Policy in the 2000s (Washington, DC: Institute for International Economics). Messerlin, Patrick A. (2002) ‘Unilateral Liberalization and Regional Integration in Central Europe’, in Jagdish Bhagwati (ed.), Going Alone: The Case for Relaxed Reciprocity in Freeing Trade (Cambridge, Mass.: MIT Press). Panagariya, Arvind (1996) ‘The Free Trade Area of the Americas’, The World Economy, vol. 19, no. 5, pp. 485–516. Pellegrin, Julie (2001) The Political Economy of Competitiveness in an Enlarged Europe (Basingstoke and New York: Palgrave).

4 Preparing for EU Membership: Restructuring the Banking Sector in Hungary György Surányi

Introduction A comprehensive reform of the Hungarian financial sector began in 1987, when the banking system was divided into two tiers. The National Bank of Hungary retained its central bank functions but its commercial banking activities were transferred to three newly established banks. The economic depression of the early 1990s severely affected the financial sector, causing a marked deterioration in banks’ loan portfolios. At that time neither the management of the institutions nor the regulatory and supervisory authorities were capable of managing the situation. After the implementation of a legislative ‘shock therapy’, which included the introduction of international standards on capital adequacy, portfolio classification and banking supervision and made formerly hidden problems visible, the Hungarian banking sector went through a costly but successful restructuring and consolidation process in 1992–94. The consolidation programme consisted of three main stages – portfolio clean-ups, enterprise restructuring and bank recapitalization – and cost taxpayers HUF330 billion, which corresponded to about 10 per cent of GDP. Hungary followed a fairly liberal licensing policy in the 1990s and imposed no special restrictions on the entry of foreign credit institutions. Almost all of the major banks were sold to strategic investors. The privatized banks received significant capital transfers from their new owners, and their risk management systems and technological infrastructure improved considerably. Financial sector regulation was modified substantially in 1997, when a new Act on credit institutions came into force. With the new legislation major steps were taken towards a universal banking system and at the same time a higher level of legal harmonization with the relevant EU directives was reached. The banking supervisory authority was also strengthened and 103

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the rights and competence of the National Deposit Insurance Fund were broadened. Reflecting a marked recovery in the real economy, the financial sector is now growing dynamically. Business expansion is proceeding alongside an improvement in the quality of services, and both the range and the volume of banking facilities have broadened significantly. The asset quality of the banking industry improved since the last steps of consolidation were taken in 1994. Capital adequacy ratios remain high in all banking categories and the sector has sufficient reserves to cover possible losses. The degree of banking sector concentration has gradually dropped to a level that cannot be considered too high in pan-European comparative terms. The success of banking sector restructuring is confirmed in reports and analyses by international rating agencies and research institutions, which in this regard place Hungary ahead of any other transition economy in the region. Nonetheless the Hungarian financial system is still weaker than those in Western countries and the prospect of EU membership is creating new challenges for the sector.

First steps of reform: the Hungarian banking sector in 1987–91 The modern history of the Hungarian financial sector began in 1987, when – after decades of a Soviet-type monobank system – the earlier two-tier banking system was re-established. The primary goal of banking reform was to promote interbank competition, which would permit the adoption of effective monetary policy and the development of healthy business relations between commercial banks and companies, free from government intervention. Prior to 1987 the National Bank of Hungary (NBH) had performed not only the country’s central bank functions but also the classical functions of commercial banks. As an important step of financial sector reform, three departments that specialized in lending were carved out of the NBH to create the foundation of three large commercial banks. Moreover the existing Hungarian Foreign Trade Bank and the National Savings and Commercial Bank, which had a strong retail basis, became fully chartered financial institutions. The newly established banks inherited a customer base whose creditworthiness eroded drastically in the subsequent years. A major flaw in the reform was that the new banks were not equipped with an adequate capital base and lacked sufficient reserves at the time of establishment. In the early 1990s, when the financial sector was hard hit by the economic depression, a considerable proportion of the banks’ loan portfolios became non-performing. Improper risk management and loan evaluation practices, inexperienced management and staff, and relatively lax banking regulation and supervision all contributed to the deterioration of the sector’s asset quality.

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It is important to stress that bad debts were not only inherited from the past – in which case the whole issue would merely have been a stock problem – but were also generated by the banks themselves, which was clearly a flow problem. The two cases had to be treated differently: welldesigned state intervention was required to solve the stock problem, while comprehensive changes in the regulatory framework and bank management were essential to prevent the revival of the bad loan problem. Non-performing loans, two thirds of which were accounted for by about 50 large firms, were concentrated among the large domestic banks. This high concentration of impaired assets did not change significantly over time and created an unfavourable situation that endangered not only the creditor banks but also the entire banking sector, and ultimately the whole economy as well. Another onerous legacy of the past was the high sectoral concentration of bank clientele. Since the three large state-owned commercial banks were formed from three different financing directorates of the central bank (industrial, food processing and infrastructure), the portfolios of these institutions were insufficiently diversified, and consequently they were very vulnerable to sectoral shocks. Because of the stagnation and recession from the late 1980s and the collapse of CMEA in 1991, almost every bank fell into difficulty in the early 1990s. The entry of foreign banks did little to reduce the high degree of concentration in the banking sector as they mainly provided services for foreign firms and joint ventures, and only the best domestic firms were accepted as clients. The portfolios of these institutions were not burdened with bad debts, they had access to cheap foreign financial resources of their parent banks, and sometimes enjoyed tax preferences as well. Not surprisingly the large domestic banks could not keep pace with the sound foreign ones, and had to maintain high interest margins to cover possible losses. Although the bad debt problem in Hungary was predominantly a stock issue in the early 1990s, it was not the inherited portfolios but rather the inherited clientele in which the core of the problem was rooted. Having no other option the large domestic banks simply rolled over a significant part of their loan portfolios. In the meantime, due to the inadequate domestic accounting rules the banks earned huge profits that the state could tap in the form of profit tax or dividends. At that time the legal regulations did not allow banks to accumulate tax-free provisions. As a solution to the bad-loan problem, debt for equity swaps became increasingly popular among domestic banks. In the short run it was favourable for both parties, but it soon turned out that this kind of investment was less profitable than expected. Nevertheless the banks hoped they could sell their stakes in forthcoming privatizations. Apart from some exceptional cases, however, banks usually suffered losses on their investments.

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Another important characteristic of the Hungarian banking sector at that time was that large debtors (large state-owned companies) were also shareholders of the financial intermediaries and they delegated their members to the boards of banks as well. This cross-ownership proved to be a major factor in allocative inefficiency. It was clear that this ownership structure was not desirable for the development of the banking sector and that fast and efficient privatization was essential. However neither private individuals nor the very weak domestic institutional investors showed much interest in buying stakes in troubled banks. The only possible solution seemed to be to sell these banks to foreign strategic or institutional investors, but then the economy fell into a very deep recession and interest in purchasing the troubled Hungarian banks vanished completely. The only solution left to the government was nationalization, and the State Property Agency and Ministry of Finance acquired a significant portion of state companies’ stakes in banks.

The legislative shock therapy of 1991 Backed by international financial institutions, the Hungarian government and the financial authorities decided to implement a comprehensive legal framework for the operation of the financial system. In 1991 the parliament passed several new economic laws. In addition to Acts on investment funds and the NBH, three other important changes in the legislation should be mentioned here. First, Act LXIX of 1991 on Financial Institutions and Financial Activities (The Banking Act), which took effect in December 1991, brought radical changes to the regulation of financial institutions. Among other things the Act required banks to accumulate loan loss provisions, prescribed an 8 per cent capital adequacy ratio by January 1994 and introduced other elements of prudential regulation, such as limits on large credits and connected lending. The Act largely followed the BIS accords, although in some important respects the regulators adapted the requirements to local conditions. While universal banking was not explicitly allowed, in practice commercial banks could trade in securities and run investment funds via their subsidiaries. Second, Act XVIII of 1991 on Accounting, which took effect on 1 January 1992, harmonized Hungary’s accounting rules with the international (IAS) standards to a considerable extent. Finally, Act IL of 1991 on Bankruptcy, Liquidation and Final Settlement (The Bankruptcy Act) came into effect in April 1992 and immediately multiplied the number of bankruptcies and liquidations. The Act set up very strict rules aimed at restoring financial discipline in the economy. This legislative shock therapy had an unprecedented impact on the financial sector. Banks were largely unable to accumulate the necessary amount of loan loss provisions even though the Hungarian rules were less stringent than the international standards. The capital adequacy of the banking

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system did not reach the required minimum, with a couple of institutions having negative own-funds. The economic crisis worsened in 1992, and due to the new Bankruptcy Act insolvent firms could no longer avoid bankruptcy or liquidation. The financial shock hit the Hungarian banks when most of them were seriously undercapitalized. However it should not be forgotten that the new banking regulations merely made visible what had been hidden before. The general fear that trust in the banking sector would be undermined made it inevitable for the government to intervene in order to strengthen the troubled financial institutions.

Banking system rehabilitation – dealing with the bad debt problem Successful systemic bank restructuring required unviable banks to be closed or merged, the remaining banks’ balance sheets to be strengthened and action to be taken to address the original cause of distress. Those governments in Central and Eastern Europe which had chosen to take direct action faced two main alternatives for dealing with the bad debt problem: they could follow a ‘decentralized’ approach (as Poland did with commercial banks and Hungary, partially, with commercial banks, the so-called loan consolidation programme) whereby individual banks would lead the financial restructuring process (or, more modestly, retain responsibility for loan recovery) with assistance from the state; or they could follow a ‘centralized’ approach (as did the Czech and Slovak Republics and Slovenia, and partially Hungary) by carving out bad debts, placing them in a central agency for collection or liquidation, and recapitalizing the banks. In ‘decentralized’ cases, banks were appointed as lead restructuring agents because they were presumed to know the circumstances of enterprises better than non-banks, and they could serve as a vehicle for decentralized debt resolution. Governments not only knew less about the enterprises than the banks but were also vulnerable to bureaucratic and political factors that could slow the enterprise restructuring process. The banks were expected to conduct analyses of problem debtors to determine the level of debt owed and how the principal should be repaid and the interest serviced; restructure the debt of potentially viable enterprises; finance the physical restructuring of potentially viable enterprises; exercise corporate governance over these enterprises; and write off the debts of, curtail new credit to and in some cases liquidate unviable enterprises. This proved to be an overly ambitious conceptualization of the banks’ capacity to assist general enterprise restructuring. In ‘centralized’ cases, governments took the lead in restructuring banks (and sometimes enterprises) through recapitalization. This primarily involved carve-outs, but bank rehabilitation agencies were involved in a few cases. All the Central European countries recapitalized their state-owned

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commercial banks at least once. The various approaches to the restructuring of banks involved changes in governance, management and operations at a time when the legal and regulatory framework was changing dramatically. While governments were correct in believing that most banks lacked institutional capacity, the government-led approach had two major shortcomings: the maintenance of an active state role in the economy, and obstruction of or delays to privatization, including the delay of much needed foreign investment in the banking sector. Centralized approaches appear to have worked only where the legal and regulatory framework was adjusted to enhance competition and transparency.

The Hungarian consolidation programme At the end of 1991 the government guaranteed half of the doubtful loans inherited by the commercial banks from the National Bank of Hungary, but this only brought temporary relief. In 1992 the full effect of the new bankruptcy legislation started to be felt and the rules for asset qualification became stricter, which caused the volume of bad and doubtful loans to increase dynamically and made immediate rehabilitation necessary. Bank-oriented loan consolidation By the end of 1992 it was clear that rehabilitation of the banking sector could no longer be postponed, because without it the banks would lose their capital and the deposits of their clients. In accordance with prevailing approaches and the practical possibilities available, a loan consolidation programme was duly launched. The partially centralized portfolio clean-up put into action by the government in December 1992 embraced banks with a capital adequacy ratio of less than 7.25 per cent. Fourteen commercial banks and 69 savings cooperatives took part in the programme. In March 1993 the banks were able to sell to the state their claims against domestic business organizations that were classified as bad in their portfolios. Assets classified as bad prior to 1992 were purchased at 50 per cent of par value, while those classified as bad in 1992 were purchased at 80 per cent. Certain claims outstanding against specific companies were purchased at 100 per cent. The government bought up loan and interest claims to a face value of HUF102.5 billion and paid for them with HUF81.3 billion of loan consolidation government bonds specifically issued for the purpose. These were negotiable, 20-year maturity, adjustable-rate bonds indexed to the marketdetermined interest rate of treasury bills, and interest payments would be credited once a year. The state also sold a package of bad loans with a face value of approximately HUF40 billion to the nearly 100 per cent stateowned Hungarian Investment and Development Bank. The portfolio clean-up programme substantially improved the situation of the affected banks and the aggregate indicators of the entire banking system.

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At the end of 1992 the total amount of problem loans fell from HUF288 billion to HUF186 billion and bad loans declined from HUF186 billion to HUF84 billion. The provisions of the banks decreased and the institutions reached a positive capital adequacy ratio, calculated according to the Hungarian standards. However the rehabilitation effort left the organization, management and operating systems of the banks largely unchanged. Enterprise-oriented loan consolidation In the second half of 1993 the government bought the debts of certain companies. Twelve large, state-controlled enterprises were selected, based on their strategic importance. A proportion of their outstanding debts to the state was forgiven or rescheduled, and then the government purchased a substantial share of their debts to creditor financial institutions by issuing consolidation bonds (at 90–100 per cent of par value). The banks received HUF57 billion of loan consolidation bonds during this phase of rehabilitation. The assets of enterprises whose majority owner was the State Property Agency or the State Property Management Corporation were also obtained by the government at that time, and these were later sold back to the two state agencies so that they could be disposed of under the reorganization plans for the enterprises in question. The recapitalization of banks By 31 December 1993 the portfolio of problem claims in the banking sector had risen to HUF352 billion (as measured by the old accounting standards), of which bad debts accounted for HUF186 billion. With the adoption of the new Banking Act that month, the rules on classification and provisioning were adjusted to the international standards. According to the new rules the value of bad, doubtful and substandard assets amounted to HUF418 billion on 31 December, of which bad debts accounted for HUF243 billion. This deterioration was partly due to the continuing economic depression, and partly to the fact that the lending practices of banks still needed improvement. Because of this the introduction of another comprehensive rehabilitation programme became inevitable. Taking into account the recommendations of international organizations, the government decided to proceed in a different way: to recapitalize the banks instead of cleaning up their portfolios. Again the government issued consolidation bonds. The recapitalization was undertaken in three steps. In the first step, at the end of December 1993 eight banks received capital injections of HUF114.4 billion, which enabled them to raise their capital adequacy ratios above 0 per cent. Capital and subordinated loans were also provided to the National Savings Co-operatives Institution Protection Fund and to the National Savings and Commercial Bank. Altogether HUF130 billion of consolidation bonds were transferred to financial institutions.

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In the second step, in May 1994 the government offered additional capital of HUF18 billion to the banks participating in the restructuring so that they could reach a 4 per cent capital adequacy ratio. Through this recapitalization the government’s holdings in seven of the eight banks participating in the programme reached or exceeded 80 per cent. In the third step, in May 1994 a subordinated loan of HUF15 billion was granted to four banks (including three large ones) to enable them to reach an 8 per cent capital adequacy ratio, based on their portfolios and classifications as of 31 December 1993. This transfer did not impose an additional strain on the budget since the banks paid interest into the budget at an identical rate to that of consolidation bonds. By means of this consolidation programme the banks were able fully to replenish their risk provisions, and accordingly their problem assets remained in their portfolios. The financial institutions concerned were obliged to set up a restructuring plan and participate in the rehabilitation of bankrupt enterprises. The banks either managed the bad loans themselves, or transferred them to work-out organizations that specialized in the management of such claims. The increased state holdings in the participating banks enabled the government to require (under the so-called ‘consolidation agreement’) that the banks modernize their systems of control, organization and operation, so among other things their loan appraisal, risk and asset classification procedures were updated. After the conclusion of the bank consolidation scheme one of the largest banks (The Budapest Bank) asked for and received additional consolidation bonds worth HUF12 billion to avoid capital reduction. This contribution was conditional on the bank being privatized by the end of 1995, otherwise the bonds would have to be returned to the government. This condition was met and the government repurchased the bonds out of the privatization proceeds. In early 1996 two relatively large banks – Mezõbank and Agrobank – merged, and at the same time received a capital injection of HUF9 billion. In the same period, as a supplement to the consolidation scheme the government offered guarantees for the net value of the claims transferred by two banks – the Hungarian Credit Bank and Mezõbank – to the work-out companies. By the end of 1994 consolidation bonds to the value of HUF330 billion had been issued in the consolidation scheme (equivalent to 9.4 per cent of GDP 1993), which increased the net debt of the country by HUF300 billion, HUF30 billion having been transferred as subordinated loans. By mid 1996 the value of the consolidation bonds issued had reached HUF360 billion as a result of individual actions. Hence rehabilitation had not been cheap, but it was a precondition for privatization and from this point of view it was clearly successful. Various indicators in the post-rehabilitation period support this statement as the capitalization, profitability and portfolio quality of the banks participating in consolidation had improved considerably.

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Privatization of state banks Under the terms of the Banking Act of 1991 no single entity – with the exemption of financial institutions – was allowed to have a direct or indirect ownership share of a bank in excess of 25 per cent of the equity. The state had to comply with this rule until the end of 1996. The Act also restricted the voting rights of the state as an owner after 1 January 1995, but this deadline was later extended. The ownership limit was reduced to 15 per cent by new legislation in 1997, and now the state may have a higher share only in exceptional circumstances and only for a temporary period. The Banking Act also stipulated that the financial institutions had to renew their licences and that the different types of share had to be converted into registered shares, which made the ownership structure of banks more transparent. Unfavourable macroeconomic conditions in the early 1990s severely hindered the privatization of state-owned banks, and we should not forget that the net worth of the major Hungarian banks had been negative prior to the government actions described above. The Hungarian authorities drew up a privatization strategy in which the selling of bank shares was combined with a further capital increase by the new strategic investors. All the investors who obtained control over domestic banks were foreign financial institutions. Of the five large state-owned banks the Hungarian Foreign Trade Bank was the first to be offered for sale. In late 1994 and mid 1995 stakes of 25 per cent and 16 per cent were acquired by the German Bayerische Landesbank and the European Bank for Reconstruction and Development (EBRD) respectively. After purchasing the shares the two investors also subscribed to newly issued shares. Later both the EBRD and the state sold their shares to the German bank. A large Hungarian retail credit institution – the National Savings and Commercial Bank – was privatized in successive stages. First, nearly 20 per cent of the bank’s equity was offered for sale to Hungarian investors in 1994. A year later 21 per cent of the shares were transferred to social security and pension funds and municipalities. Foreign institutional investors could acquire another 20 per cent and employees purchased 5 per cent. The next 8 per cent of shares were offered to small domestic investors in 1995, with the remainder being sold in 1997 to foreign and domestic institutional and private investors. The bank now has a very diverse ownership structure with no dominant investor, and its shares are quoted on the Budapest Stock Exchange. The EBRD participated in the privatization of another large Hungarian financial institution, Budapest Bank. Together with the American company General Electric the EBRD purchased a majority stake in the bank in December 1995. Under the terms of the privatization contract, a year later the Hungarian state had to buy back Polgári Bank (a retail banking

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subsidiary of Budapest Bank) from the new owners. Polgári Bank was later sold to another domestic bank, with which it merged. The next large bank to be privatized was the Hungarian Credit Bank. The Dutch ABN-AMRO purchased nearly 90 per cent of this bank’s equity at more than 200 per cent of face value. Although the bank was in a very bad financial state in the early 1990s and its consolidation had cost taxpayers a lot, the successful restructuring resulted in this most favourable purchase price. Shortly after the privatization the new owner increased the capital of the bank, making it financially strong again. The privatization of another large domestic bank, the Commercial and Credit Bank, was completed in 1997. In a two-round tender a consortium consisting of the Belgian Kredietbank and the Irish Life Insurance Company obtained a 10 per cent stake in the bank for $30 million, equalling 567.3 per cent of the shares’ face value. As in the case of the Hungarian Credit Bank, the new owners did not require any special guarantees from the government other than the standard ones. The bank’s capital was increased by $60 million later that year. The EBRD also took part in the transaction by converting $30 million of its subordinated loan capital to registered capital. A less spectacular but equally important step in the privatization process was the case of the Central European International Bank. The National Bank of Hungary had a 34 per cent stake in this majority foreign-owned institution, which had a special offshore status in Hungary. The central bank sold its shares to one of the original foreign owners in 1997, thereby withdrawing from commercial banking activities completely. At the beginning of that year all the former privileges of the Central European International Bank were revoked. Besides the privatization of large credit institutions, two medium-sized banks were sold to foreign strategic investors in 1997. Deutsche Genossenschaftsbank purchased a 61 per cent stake in the Savings Cooperative Bank at 532 per cent of the face value of the shares. Since this institution was a so-called ‘umbrella bank’ of the Hungarian cooperative credit institutions, strategic voting rights were extended to the cooperatives. The other medium-sized bank to be privatized in 1997 was the Agricultural Bank, which was sold to the Austrian Erste Bank well above the face value of the shares. In both cases the new strategic owners duly injected the capital they had pledged. The foregoing discussion clearly shows that bank rehabilitation and privatization were closely linked in Hungary. The dominant state ownership was a hindrance to the formation of a truly competition-oriented, effective and innovative banking sector. Following adequate internal modernization the state banks – recapitalized to the minimum necessary level, equipped with transparent portfolios and the necessary provisions – were able to attract private investors.

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Lessons learned from the consolidation and privatization processes Despite some painful experiences in the early stages of bank rehabilitation, Hungary successfully completed its bank restructuring programme. Listed below are a number of lessons to be drawn from Hungary’s experiences in the 1990s: ●

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State-owned commercial banks must be viewed as independent financial entities in need of capital to strengthen their lending capacity, and not simply as sources of revenue for the budget. The longer the consolidation procedure lasts the higher the expenses are, mainly because of the moral hazard of involved parties. As far as possible, costs should be properly identified in advance. Consolidation of the banking sector should be linked to enterprise restructuring. Without strengthened financial discipline in the corporate sphere, banking sector rehabilitation cannot be successful. In order to avoid expectations of future government support, the recapitalization of banks should be directly linked to the privatization process. Strict competition between prospective investors as well as transparency of the privatization process should be maintained until the last step of the transaction. Political or other interest groups and rival banks should be kept away from the privatization process. The privatization method adopted should ensure that the governance of a bank will be independent of the state and the existing bank management. This goal is most likely to be achieved if a strategic investor obtains a significant stake in the bank. Non-state core investors who are able to exercise managerial control should be encouraged. In particular, strategic foreign investors are a positive means of introducing independent management. There should be no restrictions on the entry of foreign banks or the purchase of existing banks by foreigners. The supervisory agency must be equipped with adequate financial resources and a well-trained staff, and must have the power and authority to take timely corrective action. Close cooperation with the auditors is also inevitable. Banking supervisory agencies should be independent of the government and protected from political pressure. Regulatory policy should foster a competitive market structure. Bank consolidation should be encouraged if it will result in viable institutions and discouraged if concentration is likely to choke competition. Banks should adopt international accounting and asset classification standards for their everyday operations. A stable legal environment – including banking, corporate and bankruptcy laws, effective law

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enforcement and well-defined property rights – is a necessary precondition for a sound banking system.

Recent trends in the Hungarian banking sector The Hungarian financial system has continued to move closer to Western standards since the consolidation process was completed. Growth in the banking sector has exceeded both the inflation rate and nominal GDP growth since 1997. After a period of decline in 1991–96, the sector’s balancesheet to GDP ratio began to rise and currently stands at around 75 per cent, which is still relatively low in international comparison. Hungary’s dynamic macroeconomic environment has been a major factor in the growth of the banking sector. The rise in domestic consumption has lagged behind GDP growth, and the country’s external balance has improved as well. The inflow of foreign direct investment has exceeded the current account deficit, allowing Hungary’s net debt to fall further. Moreover consumer price inflation has been declining. The corporate sector, whose economic performance has been quite spectacular, accounts for a growing share of national income, which is reflected in increased profits and investment activity. The increase in the borrowing requirements of the enterprise sector is mostly satisfied by domestic banks, while net borrowing by companies abroad has barely changed. Foreign funds are effectively channelled to the sector via the domestic banking system. The aggregate figures on the performance of the banking sector also reflect the favourable development of the economy. The dynamic rise in long-term corporate borrowing deserves special mention, as this indicates that economic agents are looking positively towards the future. Despite rapid growth, the share of non-bank institutions in financial intermediation is still rather modest in Hungary. Nevertheless an increasing proportion of household savings is managed by institutional investors, especially investment and pension funds. For obvious reasons, non-bank financial intermediation is not independent of the banking sector. Most banks have investment firms as subsidiaries, and some are operating investment funds, home savings associations, pension funds and insurance firms. The entities within the group thus offer each other’s products and services, which is a major step towards universal banking operations. The government’s privatization strategy of selling most Hungarian banks to strategic professional investors has proved successful. Earlier difficulties experienced in the banking sector – that is, the deterioration of asset portfolios and continuous loss of equity – have been effectively resolved by the concerted action taken to restore banks’ financial soundness and place them in private hands. As a result of this operation, the Hungarian banking

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sector is today regarded as more successful than those in the other countries of Central and Eastern Europe. The degree of banking sector concentration gradually fell in the 1990s and today it is not considered too high by European standards. The five largest Hungarian banks have lost some of their market share, and this has been accompanied by the dynamic growth of medium-sized entities, which are regarded as the most homogeneous group of banks as almost all of them are following an expansive market strategy. The performance of small banks has been very diverse, with some enjoying spectacular growth and others losing market share. Business expansion has proceeded together with improvement in the quality of financial intermediation, and both the range and volume of banking facilities have broadened significantly. Retail products and services represented the most important area of development in the late 1990s. Banks that formerly served only high-income clients have begun to court new customers whose incomes are somewhat lower but regular. Similarly banks that previously financed only large companies are now tending to the needs of viable medium-sized enterprises, while other banks that traditionally focused on providing mass banking products are trying to attract more elite customers. Although some banks place retail lending at the centre of their business objectives, this activity is still relatively underdeveloped in Hungary.

Preparing for EU membership – the new banking legislation Changes in the regulatory environment had a considerable impact on banking sector operations in the 1990s. As part of the move to harmonize Hungarian legislation with EU laws and meet obligations arising from Hungary’s membership of the OECD, the Act on Credit Institutions and laws governing special types of depository institution, such as home savings associations and mortgage institutions, entered into force in 1997. The Act includes rules on the deposit insurance scheme and the rights of the National Deposit Insurance Fund – which was previously regulated by separate legislation – have been broadened. The fund insures registered deposits up to the amount of HUF1 million (ca $5000), and under the Act the fund is permitted to take preventive action against the ‘freezing’ of deposits. The fund can also grant credits and subordinated loans, and obtain ownership holdings in troubled financial institutions. New types of financial institution have appeared and more stringent prudential banking regulations have been implemented. The system of licensing has been changed significantly, and the minimum amount of registered capital necessary to establish a bank has been doubled to HUF2 billion (approximately $10 million).

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In an important step towards universal banking operations, the Securities Act of 1997 allowed credit institutions to engage in some investment banking activities, such as trading in government securities in the open market and organizing public offerings. The remaining restrictions were lifted at the beginning of 1999 and thereafter banks were allowed to trade in all kinds of securities. Since universal banking requires a new type of supervision, in 1997 the previously separate areas of banking supervision and securities and exchange supervision were made the responsibility of a single new agency, the State Banking and Capital Markets Supervision Authority. As a further step towards legal harmonization and to meet OECD membership obligations, foreign banks have been allowed to open branches in Hungary since the beginning of 1998. However the Act on Credit Institutions still treats Hungarian branches of foreign banks very similarly to subsidiaries, that is, minimum capital requirements have been set and all prudential requirements must be met at the branch level. As a result of all these developments, one can say that Hungarian banking legislation is now in line with EU standards.

5 EU Accession and the Evolution and Design of Competition Policy: The Case of Hungary1 Ádám Török

Introduction New institutions can be built and new laws adopted during the course of transition, but creating effective markets is not solely a policy issue. Good cooperation between legislators, governments and players in the markets is needed to establish a regulatory framework in which competition can unfold from the traditionally monopolistic market structures in transition economies. This chapter shows how Hungarian competition policy has had to adjust continuously to ‘moving targets’: the new developments in market structures and behavioural patterns produced by economic transition. We shall not provide a comprehensive picture of the development of competition policy in Hungary, or even less in the world.2 Rather the emphasis is on ‘transitional’ elements of competition policy – those features which will disappear once the markets have become truly competitive. Attention will also be paid to the ‘exotic’ elements of competition law and policy that arise out of transition and accompany the process. Economic transition in the Central and East European countries (CEECs) has not brought about miracles or involved a fast-track approach in terms of institutional development: reducing tariffs and removing trade barriers can go a long way toward promoting competition, particularly in small countries, by imposing world prices (adjusted for transport costs) as an effective ceiling on domestic prices. Improving market infrastructure, both physical facilities and services, is also critical … these efforts need to be complemented by regulation of natural monopolies and by antimonopoly law to ensure efficiency and protect the public from the abuse of monopoly power. 117

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Both are difficult areas and further examples of the tension between the need for a strong state and the need for constraints on state power. (World Bank, 1996, p. 92) This view is indirectly supported by Lloyd (1998), who explains the growing international interest in competition policy by reference to the fact that trade and capital liberalization have not eliminated the more sophisticated barriers to capital and trade, whereas ‘one particular effect of globalization has been to change profoundly the nature of competition in markets for goods and services’ (ibid., p. 161). Thus the transition of market structures in the CEECs has taken place during a market transformation process of global importance. Hungarian economic policy has produced a string of positive and negative examples of attempts to create effective markets. The first notable attempt was the system of ‘competitive’ pricing, introduced in 1980 (Brada et al., 1994, pp. 5–7). This was softened considerably in subsequent years and ultimately remained but one episode in the history of economic reform, but its main idea of emulating competitive pricing or transferring its techniques from world markets to a non-capitalist and non-open economy was not really abandoned until it became possible to set up the institutions and legal frameworks required for a market economy.3 Our analysis of the development of Hungarian competition policy goes beyond the mainstream transition literature in assuming that the bulk of the transition process has now been completed. There is, however, a long way to go from successful transition to readiness for integration. Our main focus is on competition policy as a tool for preparing Hungary for European integration. The discussion draws on transition-related competition policy literature as a starting point (for example Slay, 1996; Fingleton et al., 1996). These analyses offer in-depth assessments of competition legislation, institutions and policies in the CEECs, but they do not explain or assess the differences between first-generation and second-generation competition policies (the latter were introduced in some CEECs after 1996).

Legal and institutional development The first Competition Act (the Law on the Prohibition of Unfair Market Behaviour, LXXXVI/1990) created a legal framework for setting up and running competition policy institutions in Hungary.4 This legislation was relatively transition-oriented in that it was intended to build up an effective and modern competition policy. Some of its elements, however, did not conform to EU requirements, as laid down in the Europe Agreement of 1991. It was therefore replaced by the second Competition Act on 1 January 1997. The second Competition Act (the Law on the Prohibition of Unfair Market Behaviour and Limitations to Competition, LVII/1996) may be considered

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as a long-term framework for Hungarian competition policy. The regulatory changes it brought about were quite significant, yet its economic and industrial organization provisions remained basically the same.5 Its title includes reference to anticompetitive practices, which – as opposed to the term ‘fairness’, with all its legal and moral underpinnings – seem to dominate the application of competition laws in developed market economies. Current Hungarian competition policy focuses on antitrust measures in the case of cartel formation, abuse of dominance and merger control. The counterparts to these elements of Hungarian competition regulation are paragraphs 85 and 86 of the Treaty of Rome (paragraphs 81 and 82 of the Amsterdam amendment of the treaty) and European Council Directive 4064/1989. We shall exclude subsidy-related problems and the regulation of natural monopolies and state enterprises from our analysis because in Hungary these have been left under government control (for example the Ministry of Finance not only executes but also controls subsidy policy). Is there a place for transition-oriented competition policies? The answer to the above question is probably yes, in line with the World Bank assessment quoted above. More active competition policies are needed in countries where the appropriate legal framework may exist but market structures are still far from competitive: ‘The need for competition policy arises because the free functioning of the market does not always guarantee effective competition and the absence of effective competition may entail substantial welfare losses for a society’ (Fingleton et al., 1996, p. 8). The pattern of development of national competition policies is, however, quite uncertain: there is a ‘lack of agreement among countries on the objectives of competition policies’ (Lloyd, 1998, p. 179). This is meant in a broad sense, but in a narrower setting it also holds true for transition countries (cf. Fingleton et al., 1996). Our overview of the case structure of Hungarian competition policy and its development will show that the onset of the second period of competition policy preceded legal change. To our mind, the period 1990–94 constitutes the first period of competition policy in Hungary, in the course of which comprehensive trade liberalization took place, widespread privatization was carried out in manufacturing and services, and many aspects of a modern system of economic legislation were adopted.6 Deep ‘transformational recession’ could not be avoided by means of policy and legal changes in Hungary (World Bank, 1996, p. 143). The stabilization package introduced in 1995 checked the economic growth that was slowly unfolding at the time, but it did help to improve Hungary’s mixed transitional performance, with its relatively poor macroeconomic indicators that failed to reflect the considerable measure of institutional and legal development. The appreciable improvement in macroeconomic indicators from 1996 onwards largely contributed to Hungary being accepted by the

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EU for the first round of accession negotiations. These negotiations were partly based on the evaluation of Hungarian competition policy against EU requirements.7 The changes in Hungarian competition legislation between Competition Acts 1 and 2 explicitly reflected the recommendations of the White Paper.8 Four fields of Hungarian competition law were modified: rules on state subsidies, merger control, cartel formation and abuse of dominance (that is, classical antitrust legislation), and state monopolies and state enterprises. Some of the recommendations in the White Paper will be addressed below in relation to specific points of Hungarian competition law and its application. Changes in competition law induced by the Europe Agreement Some of these recommendations had already been incorporated in Hungarian competition policy before the second Competition Act was adopted (Vissi, 1995), others were included in the second Competition Act in compliance with the Europe Agreement. The latter were as follows:9 ●

●

●

●

The new Competition Act covered all legal persons appearing as players in relevant markets, as specified by the law. The predecessor of this Act covered only ‘entrepreneurs’ (paragraph 1), a vague term for market players. On the basis of that definition a non-profit organization could, or at least in theory, have gone unsanctioned for displaying any kind of anticompetitive behaviour. The cartel regulations now explicitly addressed all competition distortions, all vertical restraints and other disruptions to competition. The first Competition Act had not covered vertical restraints. The definition of ‘abuse of dominance’ in the second Competition Act was identical to that used by the European Court of Justice. The new criterion for abuse of dominance, therefore, was not only quantitative10 but it also included qualitative elements. This change, however, was primarily applicable to cases assessed by the competition authority. In cases where authorization by the Office of Economic Competition (OEC) was required, quantitative limits still enjoyed priority. Tie-ins and price discrimination were also deemed to constitute an abuse of dominance. The Europe Agreement did not seek complete harmonization of Hungarian merger control with the EU system.11 Nonetheless the Hungarian regulations bore many similarities to those of the EU. For example, a negative approach was applied, that is, those cases were defined in which the merger could not be blocked by the competition authority.12

The second Competition Act contained a detailed list of legal forms of merger, and it gave the competition authority considerable latitude in assessing the arguments for or against a planned merger. A considerable difference between European (and thus Hungarian) and American merger control was that the competition authorities in the EU could demand the ex post breakup of large firms created through mergers that were considered

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illegal. EU merger law had the explicit purpose of monitoring the increase in market concentration13 and intervention was limited to cases in which market structures were seriously threatened by mergers. A very important difference between the first and the second Competition Acts relates to enforcement. It is probably not too much of an exaggeration to say that the first Competition Act was very poorly enforced, mainly owing to poor legislation. An appeal to a court of justice could postpone the payment of fines until the court had settled the issue,14 and no interest could be charged even if legal proceedings took several years.15 Therefore the very prospect of interest gains in the relatively inflationary Hungarian economic environment provided an incentive to appeal against rulings by the Competition Council (the arm of the Office of Economic Competition responsible for determining policy implementation), even in cases where there was no chance of the courts overruling the Competition Council’s decisions. The second Competition Act made mandatory the payment of fines immediately after Competition Council rulings, thus greatly improving enforcement. The legislative changes outlined above had much more to do with the country’s preparations for integration than with transition in the usual sense. The development of Hungarian competition policy, however, cannot be reduced to transition from one law to another. An important aspect of this development was structural change, as reflected by trends in the case structure of the decisions taken by the Competition Council.

The structure of competition policy cases16 Our structural analysis is based on annual surveys of Hungarian competition policy by the Office of Economic Competition. The overall trends during the entire transition period (1990–2002) will be analysed. We realize that simple analysis of the caseload regardless of any value indicator17 might not give a complete picture of the structural changes in competition policy. We also feel that the policy importance of a case bears absolutely no relation to its assumed value.18 Moreover it is clear that a really adequate quantitative analysis of modern competition policies needs much more sophisticated methods than ours. Interestingly however, only a few – and technically still rather conventional – econometric analyses have been conducted in this field.19 The first Competition Act defined the following eight areas of competition law: ● ● ● ●

●

The ‘blanket’ or ‘general’ clause. Unfair competition. Consumer deception. Collusion between enterprises that negatively affected or restricted competition (cartels). Abuse of market dominance.

122 EU Accession and Competition Policy ● ● ●

Merger control. Monitoring and correcting price increases in cases defined by law. Advisory work in economic policy making.20

Changes in caseload When it came to the analysis of cases, only the first six items listed above were considered to be part of competition policy, and taken together they were referred to in Hungarian legal parlance as ‘supervision of competition’:21 Most OECD countries have competition policies covering less fields. In the first place, unfair competition is outside of the scope of competition policy in the majority of countries, but it is part of the Hungarian competition law.[22] This unconventional solution can be linked, in our view, to the wider Hungarian government effort to replace business ethics as an implicit regulatory tool with legal regulation, given the poor condition of business ethics in the country. It has to be remarked as well that three OECD countries, Turkey, Iceland and Luxembourg do not have codified competition policies. This legal vacuum can be justified by the small size of the economies of the latter two (Scherer, 1994, p. 32). Both the volume and the structure of the Competition Council’s caseload changed quite significantly between 1991 and 2002 (Figure 5.1). The increase in the caseload was not matched by a similar trend in respect of judgements in favour of plaintiffs. The number of Competition Council decisions increased from 77 in 1991 to 230 in 2000, fell to 188 in 2001 and 250 200 150 100 50 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Cases adjudicated

All cases

Figure 5.1 Volume of the Competition Council’s caseload, 1991–2002 Source: www.gvh.hu.

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rose to 193 in 2002 (Gazdasági Versenyhivatal, 1998, p. 47; also available at www.gvh.hu). The actual figure for 1991 was somewhat higher because the Competition Council had to deliver ex post judgements on a number of privatization contracts with respect to their compliance with cartel regulations. The structural changes in the caseload (including lawsuits adjudicated – complete with judgements for the plaintiffs – and those dismissed) between 1991 and 2002 (Figure 5.2) reveal only one aspect of the development of Hungarian policy (or rather that of its clients’ attitudes): the structure of competition problems as perceived by market players themselves. Given the comparatively large number of lawsuits that were dismissed, the structure of competition problems seen by the Competition Council was quite different from the structure shown in Figures 5.1 and 5.2. First, the application of the blanket clause, as a typically ‘transitional’ element of competition policy, steadily lost ground to other aspects of competition law. The number of lawsuits that resulted in judgements for the plaintiffs dropped even more rapidly in 1992–96, falling from 12 to four. The main reason for this seems to have been the development of regulatory techniques and the growing number of precedents, both of which helped to reduce that segment of competition law not covered by specific regulations. Second, consumer deception23 was another transition-related element of competition policy, and a Hungarian speciality at that. Both the number and the relative share of such cases steadily increased until 2000, as did lawsuits that resulted in judgements for the plaintiffs. 100 80 60 40 20 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Miscellaneous

Merger control

Dominance

Consumer deception

Cartel Blanket clause

Figure 5.2 Structural changes in the Competition Council’s caseload, 1991–2002 (per cent) Source: www.gvh.hu.

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Third, cases of abuse of dominance became quite a regular feature, with their relative share growing slightly from 31.4 per cent to 31.7 per cent between 1992 and 1996, and their number from 32 to 52. More telling was the continuous increase in the number and importance of cases dismissed during that period (from 21 to 44). This indicates that an ever increasing number of market players regarded competition law and policy as a tool to offset their competitors’ competitive advantages outside the market. This can be considered a typical phenomenon in transition economies as competition unfolded.24 In contrast, after 1996 there was a steady decrease in the number of dominance cases, which reflected the fact that merger control had become the most important aspect of Hungarian competition policy. Fourth, the relative importance of cartel-related competition problems was consistently low. This could mean that collusion had not yet become a major element of competition distortion in Hungary, but it might also indicate that many product markets were still more or less monopolistic and no collusion was needed by dominant sellers to maintain their strong competitive positions. Moreover proving suspected collusion was not an easy task, particularly in a country whose statistical system was not up to date and comprehensive. Whatever the reasons for the relatively few instances of collusion, far fewer product markets were involved than products. Seven cases of collusion were registered in 1996, the largest number in the period 1992–96. Of those seven cases, six concerned a single product market: the retail market for beer. All six cases were treated separately because each entailed a different wholesaler that was highly active in a specific regional market. There was collusion between these wholesalers and their retail outlets on the one hand, and among the group of wholesalers on the other.25 After 1996, that is, when the second Competition Act was in effect, there was a further reduction in the relative importance of cartel cases. Fifth, in the period 1991–94 there were only about eight cases of merger control, but the number soared to 24 in 1995 with a slight rise to 25 in 1996. This trend continued until 2001, by which time merger control had become by far the most important element of the competition caseload (45.7 per cent in 2001). This type of case was called ‘merger authorization’. No application for merger authorization was rejected before 1996, and while the more rigorous second Competition Act gave rise to some rejections, their number totalled only three by 2001.26 Finally, the authorization of price increases may be regarded as a traditional function of the competition authority in the transition period as in this area it took over the duties of the communist-era Office of Prices and Materials. By 1996 cases of that kind had been gradually phased out. Does structural change mean progress? Hungary’s progress towards a more mature market economy was reflected in several ways in the structure of the Competition Council decisions.

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Emphasis shifted from blanket-clause cases and cases of abuse of dominance (both of which were typical of inherited market structures with noncompetitive elements) to cases of consumer deception and merger control. These changes reflected a pattern of structural development in which: ●

●

●

●

The rule of law had been extended to more specific cases than hitherto, thus helping to phase out the blanket clause irrespective of legal changes. The smoother functioning of markets, including increased domestic and import competition, was helping to reduce the abuse of dominance. Contrary to earlier expectations, consumer deception was not a marginal issue in competition policy. The fact that an ever increasing number of cases were reported can be taken as a sign of ‘consumer emancipation’, and it was also indicative of a shift in competitive pressure from the market to the legal system.27 No direct government intervention in the competitive process was able to reverse this trend, and the only solution seemed to lie in the development of the legal system (courts of justice and offices of attorneys), accompanied by a widespread improvement of civil law (tort law).28 The abrupt increase in the number of merger-control cases could have been linked to the completion of the privatization process – the changes in ownership between mainly private owners was resulting in an increasing concentration of ownership.

As discussed earlier, the caseload structure changed quite swiftly in the first half of the 1990s, and it may be concluded that transition in this field will be completed once the caseload structure has more or less stabilized. However the two transitional elements of Hungarian competition policy – the blanket clause and consumer deception – did not vanish from the scene as rapidly as optimists had thought in 1990. The relationship between competition policy during the transition period and its ‘transitional’ elements are examined more closely below.

Transitional elements of competition policy The blanket clause is now consigned to history in Hungary. Its existence was evidence that competition law and policy in a transition economy can contain provisions unheard of in a mature market economy. When introduced as part of the first Competition Act in 1990, the clause was widely debated in the literature (Török, 1996, p. 34). It was meant to cover all cases that implied a threat or injury to competition, but defied definition under any of the other paragraphs of the Competition Act. This negative approach was taken in order to comply with the fundamental legal requirement nullum crimen sine lege.29 The codifiers justified the need to introduce a blanket clause by arguing that the transition process might well give rise to unexpected situations that would call for legal solutions, and a blanket clause would render it unnecessary to go to the lengths of preparing and adopting different legal

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provisions to address each situation (Pogácsás and Stadler, 1993, p. 86). In this sense the first Competition Act had a superstructure of specific clauses built on the blanket clause, thereby conveying the message that freedom of competition would be protected even if an infringement was only general in character. According to this interpretation, the specific clauses embodied the competition philosophy expressed by the blanket clause in each aspect of competition policy. The blanket clause prohibited unfair market behaviour, irrespective of whether the damage was caused to competitors, consumers or both. The clause was therefore applicable to cases that were not specifically covered by any other clause in the Act (so-called ‘white spots’ or ‘blanks’). The clause was also applied in cases where consumers had been deceived by a vendor, even though the deception and the vendor’s increase in sales could not be directly linked to each other. Application of the blanket clause The blanket clause was invoked in 50 cases in 1995, but only 24 decisions were based on it. Deserving of mention are cases in which the mere ‘blanket’ character of the clause facilitated its application against forms of unfair market behaviour that had not been specifically defined elsewhere in the first Competition Act. Continental legal systems, unlike Anglo-Saxon law (‘common law’), do not automatically incorporate precedents into the body of law, and this holds true for Hungary as well. The blanket clause was partly meant to bridge the gap between Anglo-Saxon and European legal thinking. Moreover its introduction was necessary as Hungary’s completely closed legal structure would have left too many cases open to doubt and thus susceptible to legal ‘horse trading’, with a slim chance of ever reaching solutions that would be conducive to the further development of competition legislation.30 One case was indirectly linked to the stabilization package introduced by the government in March 1995.31 Two other cases were examples of unfair market behaviour involving information being withheld from customers, thus causing them considerable damage. In both cases the parties sued were banks that had changed certain business conditions (rates of interest or account charges) without giving prior notice to their customers. These cases are very telling in the context of transition economies. They reveal a certain lack of business ethics or culture, which several authors consider to be a negative by-product of transition.32 One way of understanding the purpose of the blanket clause is to see it as a confidencebuilding measure that could be phased out once a sufficiently watertight legal system was in place, but in the meantime its purpose was to offset the lack of business ethics in the country.33 The ‘precedent-creating’ application of the blanket clause during the seven years in which the first Competition Act prevailed made it possible to

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incorporate an increasing number of special cases and solutions into Hungarian competition law. Ultimately the clause made it possible to extend the applicability of other clauses to a large number of cases that the legislators had not envisaged in 1990. This extension of the scope of the law and the elimination of ‘white spots’ or blanks made it possible to prepare the second Competition Act without a blanket clause. The application of the blanket clause in the final year of the first Act (1996) underwent a considerable decline, as if to prove that the development of competition law and its application would inevitably make the clause redundant. In 1996 the clause was cited in only 20 cases, as opposed to 50 in the previous year.34 All four cases addressed under the blanket clause by the Competition Council in 1996 were in fact of minor relevance to competition policy. These cases included the sale of non-standard products, or consumer deception that was not aimed at boosting sales.35 The examples presented in endnote 35 are evidence of the blanket clause being used as a kind of panacea to resolve cases in which business practice had developed much more rapidly than commercial law. That notwithstanding, competition policy could not substitute for the work needed to develop the country’s legal system. Apart from the declining relevance of the clause for tackling real problems associated with competition policy, the progress made with the transformation of the Hungarian legal and economic systems made it necessary to abandon this increasingly obsolescent element of competition law. Moreover continued use of the clause might have created the illusion that, if it was made comprehensive enough, competition law would be a satisfactory substitute for a modern system of commercial law. The blanket clause was quite close to ‘case law’, as understood in the United States. In a quite contradictory but understandable way, this solution inspired by Anglo-Saxon legal systems helped Hungarian competition law to eliminate loopholes that persisted in its first version. It also facilitated a ‘rapprochement’ with more developed European systems of competition law.36 Consumer deception This area of Hungarian competition law had a strongly transitional character. Economic transition entailed transforming sellers’ markets into buyers’ markets, a process that took just a few years in most CEECs,37 and far ahead of the development of legal provisions to govern business. Therefore the few legal tools that were available – primarily competition law – had to be used to protect consumers from the excesses of suppliers. In the strict sense of the term, however competition law is mainly about how players should behave towards their competitors on the market, and not about consumer protection. It could be assumed that the relative weight of cases of consumer deception would reduce as transition progressed.38 Indeed there was a marked fall in the share of such cases in the Competition Council’s total caseload between 1994 (42.0 per cent of all cases) and 1996 (34.1 per cent). In 1997,

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however, consumer deception once again became the most prominent item on the Competition Council’s case list, with a share of 41.0 per cent. Then came a slow but continuous decrease to 31.4 per cent in 2001. It should be noted that these data include cases in which market competitors endeavoured to have sanctions imposed on their more competitive counterparts. Competition Council rulings in favour of plaintiffs in cases of consumer deception displayed quite a different structure (Figure 5.3), but no clear trend can be identified after an initial sharp increase.39 In any event, 40–65 per cent of cases ended with an adjudication each year. This shows that the inclusion of consumer deception in the portfolio of Hungarian competition policy was quite productive in the sense that a policy field emerged in which a certain degree of activism could be demonstrated, offsetting, for example, the apparent laxity with regard to merger control. The difference between the two trends is quite telling. It clearly shows that consumer deception was the main type of case presented to the Office of Economic Competition (OEC) for investigation and thence to the Competition Council for a decision, and that such cases had by far the best chance of securing a favourable decision from the Council. On a slightly cynical note, it was also a promising means of harming outside competitors. The apparent structural anomaly in Hungarian competition policy practice points to two important features of market development and competition during the transition process. First, consumer deception can be regarded as a problem of tort law if it is understood as a relationship between a single seller and one or more buyers. It can also be considered a problem of competition law if it is understood as a distortion of competition owing to illegal actions by a market player. If consumer deception is established as a fact, it should 100 90 80 70 60 50 40 30 20 10 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

All cases

Cases adjudicated

Figure 5.3 Cases of consumer deception, 1991–2000 (per cent) Source: www.gvh.hu.

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yield a competitive edge (or an attempt to acquire that edge) for the competitor deceiving the consumer.40 Cases of consumer deception had a relatively good chance of being given favourable treatment by the Competition Council as long as its time was not taken up by other kinds of case.41 Second, the preponderance of cases of consumer deception was due to the fact that only a small number of other types of market disturbance were reported to the OEC. The number of these is likely to increase as the market economy develops, but the microeconomic fabric of the Hungarian economy is not developed enough to accommodate the types of collusion and market conflict found in established market economies with long records of effective competition policy. Consumer deception as an element of Hungarian competition policy can be viewed as transitional in character for one simple reason: in developed market economies consumer deception comes either under tort or under competition law. In the United States and Western Europe it comes under tort law.42 The Hungarian solution of making the legal treatment of consumer deception part of competition policy was unique even for a transition country.43 The idea behind this solution was to accord competition policy political significance by showing the extent of the tasks it would confront in the initial transition phase. It was correctly predicted that consumer deception would take on great importance once consumers were exposed to aggressive competition. This prediction proved correct, but contrary to expectations the number of cases did not reduce over time, and in 1995 they were still judged to be high (Gazdasági Versenyhivatal, 1996, p. 13). Part of the explanation of this lies in the blurred borderline between business ethics and law in most if not all transition economies. Underdeveloped legal systems have many loopholes, and blanket clauses cannot be used to plug all gaps in the law.44 Business ethics cannot be instilled by use of the law alone. All market players should understand that while free-loading may yield positive payoffs for a few,45 in the end they are negative for all.46 The ‘grey zone’ between written rules of conduct (such as competition law and precedent cases) and unwritten norms will lessen once disputable forms of conduct have been conclusively defined in law as either legal or illegal. An important feature of the learning process during transition is that enterprises gradually come to see their reputation as part of their stock of assets and thus as part of their wealth. In the meantime the successful prosecution of cases of consumer deception that can be linked to a lack of business ethics is helping to prevent similar actions in the future. The big consumer deception tactic in 1995 was a series of Ponzi schemes or ‘pyramid games’,47 and 91 per cent of the total fines imposed in consumer deception cases that year were levied on the organizers of such schemes. Ponzi schemes soon disappeared from the scene, only to be replaced the following year by ‘games’ in which players had to purchase a product in order to be eligible to win an advertised prize. Firms came up with very original ways of attracting players, while the latter’s naiveté or greed meant that

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these ruses enjoyed unprecedented success (Gazdasági Versenyhivatal, 1997, p. 17). The same was true of time-share schemes for holiday apartments. Hungarian competition law was successfully applied to consumers’ complaints in this area, but in the future legal standards set down in the Europe Agreements could be used to address similar complaints.48 The relationship between competitive pressure and legal pressure on competitors was also evident in the analysis of the Office of Economic Competition (Gazdasági Versenyhivatal, 1996, p. 13). Several market players could not really distinguish between displaying good communications skills on the one hand and deceiving consumers on the other. Since Hungary still lacks modern advertising laws, many firms try to use competition law to combat competitors’ successful or innovative advertising campaigns. For example a large Hungarian pharmaceutical firm felt that the advertising strategies used by its competitors for the domestic market were distorting competition. Although the company drafted several complaints, only one of them was actually filed with the Competition Council.49 This involved an apparently independent medical doctor appearing on TV during prime time to laud the advantages of a foreign-produced drug that competed directly with a drug manufactured by the Hungarian firm. The complaint was badly thought out and worded. For example, it confused consumer deception with unfair competition in that it spoke of unfair competition as a result of consumer deception. It sought sanctions under both headings without referring to any specific paragraph or clause of the Competition Act of 1990. It also spoke of a breach of advertising law, but advertising was not covered by the first Hungarian Competition Act. Moreover the Advertising Act could only be used as a reference by courts of law, and not by the Competition Council. The ruling was of course negative and the case was dismissed. It was judged that the two drugs were not direct competitors because they could be used to treat two different diseases with the same symptoms. Analysis of the case showed that Hungarian competition legislation (the first Competition Act of 1990) was not in full conformity with the Advertising Act and the Drugs Act, which explicitly prohibited the advertising of drugs. The complaint was rejected by the Competition Council for want of evidence of both consumer deception and unfair competition, as well as for want of a ‘competitive relationship’ between the products in question.50 However the Competition Council could not rule on the basis of the Advertising Act, which the foreign manufacturer had clearly infringed. The Hungarian firm could have taken the case to a civil court but it decided against that course of action – its lawyers may have thought that competition legislation was not yet developed enough to provide them with the legal tools they needed. The above example points to two facts that are frequently not well understood by firms. First, competition law cannot be used to prevent or sanction

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breaches of other fields of commercial law. Second, legal remedy can be sought in competition law only if the products in question are competing in exactly the same market.

Conclusion: is Hungarian competition policy effective? Competition policy was an important component of the policy package assembled in the early 1990s to promote the transition process in Hungary.51 For the most part the effectiveness of other policies can be measured by macroeconomic indicators. For example monetary policy can be measured by the rate of inflation and balance of payments, fiscal policy by the budget deficit, trade policy by the trade balance, labour market policy by the rate of unemployment and social policies by life expectancy and infant mortality. The performance of competition policy, however, does not lend itself to such measurement. Judgement of the effectiveness of Hungary’s competition policy could be based on the proportion of cases in which sanctionable market distortions are found. According to Csaba (1998, p. 25) the OEC should be as active as the antitrust body in the United States (probably pre-1982). Csaba challenges the widespread view (as reflected, for example, in the country evaluation in Agenda 2000) about the relatively advanced development of Hungarian competition policy, but he also does not advocate rapid legal harmonization with the EU in this field.52 Csaba’s argument is primarily theoretical in character and is based on the assumption that stricter application of competition law would be more helpful to Hungary’s preparation for accession than the current practices of the Competition Council. The function and usefulness of competition policy might be judged in terms of it being an element of the state budget, but could such an assessment be based on a cost–benefit approach? An article in a Hungarian business weekly stated that the OEC is approaching the point when its social usefulness will be less than the amount of government funds spent on it. If there are no cartels in the Hungarian economy, if there are no real abuses of dominance, if the interests of competition and the consumers are harmed only to the extent of HUF100 million[53] a year – why is an independent government agency needed to tackle such a small problem?54 The point being made here was whether any kind of competition authority was needed during the transition process. Admittedly the fines levied by the OEC had not increased greatly over the years and totalled less than the budgetary resources allocated by the government to the OEC. In 1997 the revenue from fines reached an all-time low – a mere HUF104 million – owing to appeal-linked deferments of payment.55 Of course if competition policy

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had been based on a cost–benefit approach or if such an approach had played a part in Competition Council rulings, the argument quoted above could have been countered by increasing the fine by HUF10 million in just one of the cases. Two different questions of economic policy relevance come to the fore at this point. The size of fines was one aspect of the problem and the possible role of the OEC as a net contributor to the budget was another: ●

●

The fines levied by the Hungarian competition authority were initially very low and appeals could be used to defer payment. They are still low in comparison even with not very highly developed EU countries where, in terms of fines, unfair competition is comparable to serious criminal acts that involve economic transactions.56 A public agency cannot be profit-oriented and its performance has to be assessed on the basis of the law underpinning it. More specifically, the legal status of the OEC renders any cost–benefit comparison meaningless: the OEC’s funding does not depend on the fines it levies, and the money it collects goes directly into the state budget and the OEC has no say in its ultimate use.

The OEC is legally guaranteed political independence, so the government is unable to exert pressure on it to increase its taking. If the financial situation of the government or any other kind of fiscal constraint were to influence the work of the OEC, protecting freedom of competition would be just one of the principles of competition policy rather than its sole principle. Both the relatively high percentage of cases dismissed and the apparent tolerance of the competition authority call for explanation. Our own research and studies by other researchers suggest several quite different but plausible explanations. First, the ‘transitology’ explanation57 proceeds from the assumption that in the transition economies competition policy institutions have been given tasks that only to a limited extent correspond to their profile. Therefore they have had to specialize in fields quite unrelated to competition law (for example consumer protection). From the outset their political and administrative status was not particularly stable. The reason was their defined duties included tasks that were to be accomplished in the future, that is, in a mature market economy. The Czech and Slovak competition authorities found a solution by ‘seeking refuge in government’, and their offices were granted the status of a ministry when their first Competition Acts were adopted.58 Though weak in terms of political independence, the offices played some part in economic policy making and this helped them (as ministries) to protect their political bargaining positions. In contrast the Hungarian OEC remained independent from the government. It had no involvement in economic decision making and steered clear of economic problems that came too close to politics. This was probably one

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of the reasons why the OEC had little influence on privatization (Fingleton et al., 1996, pp. 163–4).59 The ‘transitology’ explanation provides the following description of a competition authority in a transition country. Prior to gaining political muscle the authority refrains from intervening in the economy unless the government considers that a stable market economy will need an effective competition authority in the long term.60 The competition authority adopts a disciplined, non-interventionist or self-constrained attitude that pays off in the long term, or at least for the organization itself. Second, the ‘functional’ explanation also places emphasis on competition policy institutions adjusting to transition. The reasons for their passive stance, however, are other than political: tasks set by the transition process dominate the scene, as opposed to the ‘antitrust’ tasks that are customary in developed market economies. These categories of task can be termed ‘creative’ and ‘supportive’ (Modzelewska, 1997, pp. 95–6). The time-consuming nature of the market-creation process61 and the importance of ensuring the proper sequencing of competition policy tasks was extensively stressed in early transitional literature.62 According to Modzelewska ‘creative’ tasks include: ●

●

●

●

Establishing a legal and institutional foundation for crushing monopolistic market structures. Breaking up market players with complex structures (that is, monopolistic state firms). Liberalizing imports and introducing incentives for foreign direct investment. Implementing economic policy tools, including privatization, to help domestic firms to compete.

‘Supportive’ tasks include: ●

●

Maintaining constant control of enterprise concentration, including the prohibition of mergers that could disrupt competition. Prohibiting anticompetitive behaviour, with special emphasis on collusive horizontal agreements.

According to the functional model the time of competition authorities in transition countries is taken by the fulfilment of creative tasks, although supportive tasks are being awarded increased importance as they constitute the bulk of antitrust policy in established market economies. The above synopsis of the functional explanation has not appeared in the literature in such terms, although several works have described the same model with minor differences.63 It remains an open question as to why competition authorities (as shown by the Hungarian example) are passive and tolerate a great number of market distortions. Third, the ‘market structure’ explanation is somewhat anecdotal and requires quantitative analysis.64 Therefore we can only present elements of this model. Rulings in a number of merger cases in Hungary in the second

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half of the 1990s have shown that increased market concentration does not necessarily lead to market dominance. For example: ●

●

●

Wallpapers were homogeneous products but were sold in a broad range of markets, and therefore the merger of two actors in this product area was judged unlikely to result in competition-distorting concentration. With hotel services the relevant markets were very narrow65 and import competition did not exist. The merger of two domestic hotel companies operating in largely complementary market niches increased the combined market share of the companies in question in only one relevant market out of 100. A merger case involving non-ferrous metals concerned the vertical integration of firms that prior to 1990 had belonged to a large state enterprise with a monopoly in Hungary. Thus the merger did not change the monopolistic structure that already existed in the market for aluminium products.66

The three cases outlined above illustrate only a small part of the marketstructure explanation of the seemingly lax antimonopoly policy during transition. The explanation relates to the transitional stage in which the old market structures have yet to be fully demonopolized and the ‘entrepreneurial fabric’67 of the economy is still underdeveloped. Strong import competition usually makes it difficult for domestic players to compete in many markets, and even if they joined forces they would still lack the power to drive competitors out of the market. The above examples have been taken from the area of merger control where the laxity of Hungarian competition policy is not only apparent but also seems to be in line with the structure of the EU merger caseload,68 and with the experiences of a number of other transition economies. In addition to the three explanations presented here, a number of others have been suggested.69 These include the widening of markets as a result of trade liberalization following the realization of the Europe Agreements and the creation of CEFTA, certain industrial policy instruments that are hidden in national merger legislation, the prevalence of ‘rule of reason’ approaches to cases,70 a quite large number of merger applications that have been neither approved nor rejected,71 and a bias on the part of competition authorities towards non-rejection so as to preserve their field of action.72 Despite its apparent laxity, competition policy during transition (especially in Hungary) seems to have been effective. The explanations detailed or hinted at above suggest that the effectiveness of competition policy has to be considered in strategic terms, and an important short-term task for competition authorities is to establish themselves within the administrative structures of the transition countries. In our view none of the explanations deserves to be awarded greater validity than the others and there is no single explanation of the apparent passivity of competition policy.

Appendix 5.1 Structure of merger decisions taken by (a) the Hungarian Office of Economic Competition (1991–2001) and (b) the European Commission (1990–2002) (a)

Cases No. submitted No. started ex officio Total processed No. authorized No. conditionally authorized No. not subject to authorization No. blocked Total final decisions

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

5

8

3

3

24

25

30

46

44

58

81

– 5 5

– 8 3

– 3 1

– 3 3

– 24 13

– 25 18

– 30 27

3 49 37

2 46 42

12 70 58

5 86 58

–

–

–

–

–

–

–

–

–

2

2

– –

5 –

2 –

– –

10 1

7 –

3 –

8 1

4 –

9 1

5 –

5

8

3

3

24

25

30

46

46

70

65

Source: Annual Reports of the Office of Economic Competition, Hungary (www.gvh.hu).

135

136

Appendix 5.1 Continued (b) Cases No. notified Phase I: No. out of the scope of the merger regulations No. compatible No. compatible with commitments Referral to member states Phase II: No. compatible No. compatible with commitments Prohibition Restore effective competition Partial referral to member states Total final decisions

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Total

12

63

60

58

95

110

131

172

235

292

345

335

277

2185

2

5

9

4

5

9

6

4

6

1

1

1

1

54

5

47

43

49

78

90

109

118

207

236

293

299

242

1816

–

3

4

–

2

3

–

2

12

19

28

13

10

96

–

–

1

1

1

–

3

7

4

4

6

1

4

32

–

1

1

1

2

2

1

1

2

–

3

5

2

21

– –

3 1

3 –

2 –

2 1

3 2

3 3

7 1

5 2

8 1

12 2

10 5

5 0

63 18

–

–

–

–

–

–

–

2

–

–

–

0

2

4

–

–

–

–

–

–

–

–

–

1

–

5

2

8

7

60

61

57

91

109

125

142

238

270

345

340

275

2120

Source: European Merger Control, Council Regulation 4064/89, Statistics (2001) (http://europa.eu.int/comm/competition/mergers/cases/stats.html).

Ádám Török 137

Notes 1. The author wishes to thank Erik Berglöf, Gábor Hunya, Michael Landesmann, Patrick Messerlin, Jerzy O´siatyn ´ ski, Sándor Richter and Dariusz Rosati for their helpful comments. All remaining errors and omissions are his own. 2. For assessments of recent global competition policy developments see Scherer (1994) and Lloyd (1998). 3. Efforts to revive the system are described in Brada et al. (1994, pp. 6–7). 4. The development of Hungarian competition policy prior to 1996 is assessed by Török (1996, 1997). 5. Information from Márta Nagy. 6. For a comparative assessment of the Hungarian transition process see World Bank (1996, pp. 12–19). 7. For these requirements see European Commission (1995, ch. 3). An assessment of their fulfilment by Hungary is provided by Kovács (1997). 8. See European Commission (1995, pp. 49–64). The White Paper contained a list of tasks to be fulfilled by Europe Agreement countries if they were to qualify as participants in the internal market. This did not mean membership, and it is important to be aware that the White Paper only reflected assessments by Commission staff, and not prior coordination with the Europe Agreement countries (Fritsch and Hansen, 1997, p. 11). Compared with the requirements laid down in the Europe Agreements, those in the White Paper strengthened adjustment-related pressure on applicants in certain areas (Nicolaides and Mathis, 1997, p. 153). 9. The author is indebted to Ferenc Vissi for his explanation of the legal changes listed here. 10. The former regulatory principle was based on a combined market share of 30 per cent for market players suspected of abuse of dominance, except of course in instances of de minimis. 11. For an assessment of the harmonization objectives set by the Europe Agreements see Holmes and Mathis (1997). 12. The conceptual background of this solution seems to reflect the far-reaching change in US competition policy thinking initiated by Robert Bork in the 1970s (see Bork, 1993), as well as the EU’s approach to merger control. Bork pointed out that in mergers that seemingly limited competition the social benefit might be higher than the social cost owing to their efficiency-enhancing effects. 13. I am indebted to Márta Nagy for this statement. 14. We shall return to this point later. 15. The only effective sanction was the exclusion of a legal person from procurement for five years in cases where the Competition Council had ruled against it, and appeals were not conducive to postponement in such cases. 16. Unless otherwise indicated the information in this section comes from Gazdasági Versenyhivatal (Economic Competition Authority) (1996, 1997, 1998). 17. Such as the structure of the caseload weighted with either the amount of fines or the size of the firms involved. This solution, of course, poses quite serious methodological problems. 18. The structure of case material changed significantly when the second Competition Act came into force because the blanket clause was eliminated from that Act and cases based on the clause disappeared after 1996. Another structural analysis problem is posed by the fact that the second Competition Act made it

138 EU Accession and Competition Policy

19. 20.

21.

22. 23. 24. 25.

26.

27. 28.

29. 30.

31.

possible to suspend a case before it had been ruled upon by the Competition Council if the defendant undertook to abide by the law. This only applied if the distortion of competition was of minor importance. As cases could be suspended for a long time it is not clear how they could be treated in a structural analysis. Examples include Dutz and Vagliasindi (1999) and Duso et al. (2003). This was a quite sensitive issue since the OEC did not belong to the government but was responsible to parliament. Being at the seniormost administrative level the OEC chairman had a standing invitation to attend cabinet meetings dealing with economic policy. Items 7 and 8 are also of importance in the broader context of competition policy. Price controls were, where mainly markets of natural monopolies were concerned, quite administrative in character, yet they could not be neglected even in a market economy. Advisory work in economic policy issues was important when bills for economic policy were prepared. Efforts to influence this legislative work in order to give more emphasis to the competition policy argument were referred to as ‘competition advocacy’ (Capelik and Slay, 1996, p. 70). Unfair competition included the misuse of business secrets, boycotting and damaging of others’ business reputation (see Fingleton et al., 1996, p. 73). The other term used in the literature is ‘consumer fraud’ (see Fingleton et al., 1996). This statement will be further illustrated with an analysis of consumer deception material. A market with one homogeneous product is highly conducive to the creation of cartels (Gazdasági Versenyhivatal [Economic Competition Authority] 1997, p. 18), in which a number of market players form a closed group in a market where demand is not dynamic and imports play only a supplementary role. Collusion is attractive under such circumstances because competitors can gain market shares only at the expense of each other and price wars would yield only losers. The six cases investigated were of wholesale firms that each had one regional market under its control. Their collusion was evidenced by their standardized sales agreement, which obliged retailers to observe minimum retail prices. The Competition Council judged these agreements to be both price-fixing agreements and price cartels (Gazdasági Versenyhivatal, 1997, pp. 18–19). This comparatively rare example of a complex cartel in Hungary thus included elements of both vertical and horizontal collusion. The relatively passive stance towards mergers was in line with EU practice, which cannot be considered overly restrictive (Neven et al., 1993; Korah, 1997, pp. 272–7). This was not the only explanation though, and other reasons for the apparent passiveness will be explained in more detail below. Together with the increasing number of cases of abuse of dominance dismissed by the Competition Council. Our analysis of the transitional elements of Hungarian competition policy will show that competition law was partly used to by-pass ineffective and lengthy legal procedures in the civil courts. The blanket clause has been defined as ‘the background rule of typical legal situations regulated by the Competition Act’ (Kaszainé and Miskolczi, 1997, p. 40). This element of the first Hungarian Competition Act bore some similarity to US legal practice in the sense that the very general rules and prohibitions left room for interpretation (Kovács, 1997, p. 116). As part of this package the government introduced an 8 per cent surcharge on all imports except energy. The firm Opel Hungary Ltd made its customers pay the

Ádám Török 139

32.

33.

34.

35.

36.

37. 38.

39.

import surcharge for products imported before this trade policy measure was adopted. The company was obliged to pay a fine and reimburse the import surcharge it had wrongly levied on its customers. ‘A culture of trust cannot be taken for granted. Trust, like reputation, is built over time and supported by the repeated observation that the law is indeed enforced. When trust is established, the rule of law operates as a self-fulfilling mechanism’ (Fingleton et al., 1997, p. 52). There were three other cases in 1995 of market players deceiving customers, competitors or third parties in the market (non-customers and non-competitors) without fulfilling the major precondition for unfair market behaviour or consumer deception: a provable motive for boosting sales. All three cases (involving a pharmaceuticals trading firm, a bank and a publishing company) were simple examples of issuing wrong information out of neglect. It is likely that in a mature market economy they would have been taken to civil court and sued for damages. This decline fitted into the longer-term trend of a decrease in the number of blanket clause cases, or to be more precise, cases in which the Competition Council’s decision was based on the blanket clause. These peaked in 1993 at 35, and stagnated at 21–24 in 1994–96. Their percentage share of all cases fell from 23.5 per cent in 1992 to 12.8 per cent in 1996, the latter share being almost tantamount to marginalization. Moreover the number of negative decisions decreased from 12 in 1992 (but 18 in 1993) to just four in 1996. In one case the vendor used a brand label that resembled another brand with an international reputation. However piracy (that is, a breach of copyright) could not be established as the two labels were not identical and the brand names were different. While the blanket clause could be used to plug a loophole in intellectual property legislation in Hungary, competition law should not be regarded as a substitute for other, less well developed fields of commercial legislation. One other case deserves special mention to demonstrate the apparent anachronism of a blanket clause in competition law in a relatively mature market economy. A renowned consulting firm was sued by its competitors for going about its business without a licence to do so. The company was fined by the Competition Council. When commenting on its decision the Council emphasized that the case would have been handled by a civil court if Hungary had had a comprehensive and modern law on legal representation at that time. For an analysis of these differences see Scherer (1994, pp. 33–8). An interesting comparative assessment of European and Japanese competition policy can be found in Rosenthal and Matsushita (1997). In the first phase of political transition consumer protection was even an election issue in some CEECs (Fingleton et al., 1996, p. 47). This argument was received with some scepticism by Márta Nagy of the Hungarian Office of Economic Competition. In her experience consumer deception was often used to gain an advantage over competitors, but the competition authorities found it very difficult to distinguish between tough competition and illegal distortions of competition. This counterargument is perfectly acceptable, but my emphasis rests on a slightly different point: cases of consumer deception would continue to account for a relatively important share of the caseloads of national competition authorities until the market microstructures in the transition economies became similar to those in developed market economies. Twenty per cent of all Council decisions in 1991 were for cases of consumer deception, followed by 42.2 per cent in 1992, 35.0 per cent in 1993, 60.4 per cent

140 EU Accession and Competition Policy

40.

41.

42.

43.

44.

45.

46.

47.

48. 49. 50. 51.

in 1994, 57.1 per cent in 1995, 57.8 per cent in 1996, 63.2 per cent in 1997, 41.7 per cent in 1998, 67.7 per cent in 1999 and 54.7 per cent in 2000. If an action leading to the deception of one or more consumers did not yield a competitive advantage it was not considered a case of consumer deception. Between 1991 and 1996 cases of this kind were dealt with under the blanket clause. The apparent ‘popularity’ of the Competition Council in cases of consumer deception may also be linked to the fact that its rulings usually take much less time than legal procedures in civil courts based on tort law. On the other hand competition law does not provide for the award of damages (information obtained from József Sárai). In the United Kingdom consumer protection is partly the responsibility of the Office of Fair Trading (the British competition authority), but its remit is limited to unfair contract terms (Oxford Dictionary of Law, 4th edn, 1997, p. 102). Practice in the European Union is similar: it sanctions the unfairness of contract terms, but consumer protection as a general term is not equivalent to obliging producers/ suppliers to provide consumers with correct information on every possible detail. Such an implicit obligation should be included in tort law and not in competition law. Of Poland, the Czech Republic, Slovakia and Hungary, only the latter country included consumer deception in its competition law (Fingleton et al., 1996, pp. 94–5). Competition law cannot be really effective in a business environment that lacks generally accepted ethical norms. No legal system can substitute for business ethics (Fingleton et al., 1996, pp. 51–4). An American survey comparing markets in Russia and Poland in 1997 offers a good example. It was found that 76 per cent of the retail shops surveyed in Moscow had to pay protection money, compared with 6 per cent of those surveyed in Warsaw. This probably explains why the density of retail shops is much higher in Warsaw than in Moscow (Newsweek, 19 January 1998, p. 22). The following are two Hungarian examples of illegal ‘hit-and-run’ market entries in the early 1990s. (1) Car dealers suddenly appeared and offered cars at prices that were significantly below those quoted by official dealers. As soon as they were paid they disappeared and the cars were never delivered. (2) Mail-order firms that appeared out of the blue sent their customers goods of much lower quality than promised in their advertisements. They too disappeared, leaving a trail of furious customers behind them. Cases such as these would have been inconceivable in a developed industrial country at the time and they are probably equally unthinkable in Hungary today. Apparently the duped customers did not realize that they could not obtain compensation from the government, as would have been the case in the past. While Ponzi schemes more properly fell under the Gambling Act, in 1995 such schemes were deemed to constitute consumer deception if misleading advertisements or false claims were used to encourage people to play. The character of these games was such, however, that it is hard to imagine that any honest advertisement or claim could have persuaded people to participate. For a comprehensive survey of the Europe Agreements see Lesguillons (1995). For a brief description of the case see Gazdasági Versenyhivatal (Economic Competition Authority) (1996), case Vj.18/1996. In competition law parlance, this means that their markets did not overlap. Erik Berglöf stated very correctly when commenting on this chapter that the proper functioning of markets requires both effective competition policy and

Ádám Török 141

52.

53. 54. 55.

56.

57. 58. 59.

60.

61.

62.

effective corporate governance. To our mind competition policy has been by far the more effective tool of the two in Hungary. For an assessment of corporate governance in Hungary see Török (1998). A strong counterargument against Csaba’s was provided by Márta Nagy in 1998. Of the 781 Competition Council rulings based on the first Competition Act, 286 were appealed against. Altogether 192 proceedings had been concluded in court by May 1998, of which only 16 had ended with the court overturning the ruling of the Competition Council. All of these successful appeals related to alleged breaches of law. Of the Competition Council rulings that were upheld the severity of none was increased and in 33 cases the fines were reduced by the courts. Eleven of these court rulings were appealed against, and in only eight cases did the Supreme Court change the sentence. All this points to a high level of conformity in the application of competition law with legal practice in the Hungarian courts of law. Approximately $500 000 in early 1998. Tóth (1998). Amendments to the competition law between 1996 and 1997 brought about a major change in the way fines were collected. The previous law had accepted future appeal as a reason for deferring payment, but the new law required immediate payment irrespective of whether the ruling would be subject to appeal. Therefore 1997 was the first year in which the amount of fines collected corresponded to the amount of fines levied. This measure was expected to improve the budgetary performance of the OEC. Prior to 1982 US antitrust law and policy was considered very strict, but prosecution remained only a theoretical possibility in almost all cases. There is at least one EU country, the Republic of Ireland, where unfair competition can have very serious legal consequences. In certain circumstances competition-related misdemeanours are considered criminal acts by courts of law. In such cases the penalty may amount to IR£3 million (roughly the same amount as in British pounds) or a two-year gaol sentence (Fingleton, 1997, p. 22). See for example Fingleton et al. (1996, pp. 171–2). The Czech competition authority became solely responsible to parliament in late 1996. This argument is not accepted by OEC staff, who insist that the Hungarian Privatization Act of 1995 gave the OEC a consultative role in privatization decisions. The OEC has been represented on the board of each privatization agency since 1992 and the opinion of its representative is usually ‘respected’ (Bodócsi, 1996, p. 274). We do not know the exact extent of the influence of the OEC on Hungarian privatization. Agenda 2000 stresses in the preamble of each of its country chapters on competition policy that the harmonization of national competition policies with that of the EU is a prerequisite for EU accession by all candidate countries (Ministry of Foreign Affairs, 1997, p. 34). ‘Market creation’ means making the greatest possible number of monopolized or oligopolized market segments contestable (Sauvé, 1996, p. 3; Fritsch and Hansen, 1997, pp. 27–8). For a comparative analysis of market creation processes in transition economies see Biesbrouck and Jackson (1995). Cf. Nuti (1993, pp. 61–3), and Csaba (1993, p. 92). Rubin (1993, p. 168) takes a quite unique position, declaring that only market actors can be wholly entrusted with the task of market creation. Therefore no competition policy would be needed during transition.

142 EU Accession and Competition Policy 63. For example Fritsch and Hansen (1997, pp. 24–32); Csaba (1998); UNCTAD (1997, pp. 229–33). 64. A good example of such an analysis is that by Fingleton (1997) on the level of development of competitive structures in the Irish economy. 65. For example three-star hotels in one geographical region. 66. There was another justification for authorizing this special merger: the ‘failing company defence’ (Montag, 1997, p. 790). The aluminium company acquired by the partner was in such dire financial straits that it would have been liquidated if the merger had not taken place. 67. In developed market economies this term means that even in narrowly defined market niches there is intense competition between a large number of market players who are also vertically and/or horizontally related to producers and products in adjacent market niches. ‘Entrepreneurial fabric’ comes from the French term tissu industriel. 68. See the tables in Appendix 5.1 Cf. European Merger Control, Council Regulation 4064/89, Statistics (2001) (http://europa.eu.int/comm/competition/mergers/cases/ stats.html). 69. We conducted an ACE-Phare research project between 1998 and 2001 on the efficiency of merger control in transition economies (Phare-ACE Project No: P97–8020-R). The participants were Ádám Török (project coordinator, Hungary), Barbara Tóth-Vizkelety (research assistant, Hungary), László Somogyi (Sweden), Jens Hölscher (Germany–UK), Johannes Stephan (Germany), Ewa Miklaszewska (Poland), Lubomir Dolgos (Slovakia), Ern˝ o Domonkos and Andreea Micu (Romania), and Peter Mikek, Monika Kranfogel Slebinger, Franjo Mlinaric and Egon Zizmond (Slovenia). The research covered Hungarian, Slovak, Polish, Romanian and Slovenian merger cases. For a summary see (Török, 2003). See also Kravtseniouk (2002). 70. On the problem of ‘per se’ versus ‘rule of reason’ treatments of antitrust cases see ABA (1999). 71. For example cases where applications are submitted only in order to test the authorities and establish contact with them, but they are not treated because they are out of the scope of national merger control systems for size-related or other reasons. 72. This behaviour was first analysed by Neven et al. (1993) and later for transition economies by Török (2003).

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Ádám Török 143 Bork, Robert H. (1993) The Antitrust Paradox. A Policy at War with Itself (New York: The Free Press). Brada, Josef C., Inderjit Singh and Ádám Török (1994) Firms Afloat and Firms Adrift. Hungarian Industry and the Economic Transition (Armonk, NY: M. E. Sharpe). Capelik, V. and B. Slay (1996) ‘Antimonopoly Policy and Monopoly Regulation in Russia’, in B. Slay (ed.), De-Monopolization and Competition Policy in Post-Communist Economies (Boulder, CO: Westview Press), pp. 57–88. Csaba, László (1993) ‘After The Shock: Some Lessons from Transition Policies in Eastern Europe’, in László Somogyi (ed.), The Political Economy of the Transition Process in Eastern Europe (Aldershot: Edward Elgar), pp. 88–107. Csaba, László (1998) ‘Közép-Európa uniós érettségér˝ ol’, Közgazdasági Szemle, vol. XLV (January), pp. 18–35. Duso, Tomaso, Damien Neven and Lars-Hendrik Roeller (2003) The Political Economy of European Merger Control: Evidence using Stock Market Data, CEPR Working Paper no. 40 (London: CEPR, February). Dutz, Mark A. and Maria Vagliasindi (1999) Competition Policy Implementation in Transition Economies: an Empirical Assessment, EBRD Working Paper no. 47 (London: EBRD, December). Estrin, Saul and Martin Cave (eds) (1993) Competition and Competition Policy. A Comparative Analysis of Central and Eastern Europe (London and New York: Pinter). European Commission (1995) White Paper. Preparation of the Associated Countries of Central and Eastern Europe for Integration into the Internal Market of the Union (Brussels: European Commission). Fingleton, John (1997) Standards of Competition in the Irish Economy, Trinity Economic Papers Series 1 (Dublin: Trinity College). Fingleton, John, Eleanor Fox, Damien Neven and Paul Seabright (1996) Competition Policy and the Transformation of Central Europe (London: Centre for Economic Policy Research). Fritsch, Michael and Hendrik Hansen (1997) ‘East–West integration and competition policy’, in Michael Fritsch and Hendrik Hansen (eds), Rules of Competition and East–West Integration (Boston, Dordrecht and London: Kluwer), pp. 7–38. Gazdasági Versenyhivatal (1996) Report to the National Assembly about the activity of the Hungarian Competition Authority in 1995 and the experiences in the course of the application of the Law on Competition (in Hungarian), Hungarian Competition Authority, March. Gazdasági Versenyhivatal (1997) Report to the National Assembly about the activity of the Hungarian Competition Authority in 1995 and the experiences in the course of the application of the Law on Competition (in Hungarian), Hungarian Competition Authority, March. Gazdasági Versenyhivatal (1998) Report to the National Assembly about the activity of the Hungarian Competition Authority in 1995 and the experiences in the course of the application of the Law on Competition (in Hungarian), Hungarian Competition Authority, April. Holmes, Peter and James Mathis (1997) ‘Europe Agreement Competition Policy for the Long Term: an Accession Oriented Approach’, in Michael Fritsch and Hendrik Hansen (eds), Rules of Competition and East–West Integration (Boston, Dordrecht and London: Kluwer), pp. 199–220. Kaszainé dr, Mezey, Katalin and Péter dr. Miskolczi Bodnár (1997) Kézikönyv a versenyjogról (Budapest: HVG-ORAC Lap-és Könyvkiadó).

144 EU Accession and Competition Policy Korah, Valentine (1996) Cases and Materials in E.C. Competition Law (London: Sweet & Maxwell). Korah, Valentine (1997) An Introductory Guide to EC Competition Law and Practice, 6th edn (Oxford: Hart). Kovács, Csaba (1997) ‘Hungarian Competition Policy during Transition and Competition Policy for Integration’, in Michael Fritsch and Hendrik Hansen (eds), Rules of Competition and East–West Integration (Boston, Dordrecht and London: Kluwer), pp. 107–24. Kravtseniouk, Tatiana (2002) ‘Merger Regulation in the Transition Economies of Central and Eastern Europe: Evidence from Hungary, Romania and Slovenia’, Acta Oeconomica, vol. 52, no. 3, pp. 327–46. Lesguillons, Henri (1995). ‘Towards an International Competition Policy?’, International Business Law Journal, no. 8, pp. 981–7. Lloyd, P. J. (1998) ‘Globalization and Competition Policies’, Weltwirtschaftliches Archiv, vol. 134, no. 2, pp. 161–85. Ministry of Foreign Affairs (1997) ‘Agenda 2000. Az Európai Bizottság véleménye Magyarország Európai Unióba történ˝ o jelentkezésér˝ ol’, Mimeo (Budapest: Ministry of Foreign Affairs). Modzelewska, Elzbieta (1997) ‘Appropriate Rules of Competition during Transformation: the Case of Poland’, in Michael Fritsch and Hendrik Hansen (eds), Rules of Competition and East–West Integration (Boston, Dordrecht and London: Kluwer), pp. 95–106. Montag, Frank (1997) ‘Neuere Entwicklungen in der Fallpraxis der europäischen Fusionskontrolle’, Wirtschaft und Wettbewerb, vol. 47, no. 10, pp. 781–94. Neven, Damien, Robin Nuttall and Paul Seabright (1993) Merger in Daylight. The Economics and Politics of European Merger Control (London: CEPR). Nicolaides, Phenon and James Mathis (1997) ‘European Community Competition Rules in Economies in Transition: the Case of Poland’, in Michael Fritsch and Hendrik Hansen (eds), Rules of Competition and East–West Integration (Boston, Dordrecht and London: Kluwer), pp. 147–66. Nuti, Domenico Mario (1993) ‘Lessons from the Stabilization Programmes of Central and Eastern European Countries, 1989–1991’, in László Somogyi (ed.), The Political Economy of the Transition Process in Europe (Aldershot: Edward Elgar), pp. 40–66. OEC (2000) Annual Report on Competition Law and Policy Development in Hungary, January–December 1999, http: //www.gvh.hu/angol/ineto6cd2.htm. Pogácsás, Péter and János Stadler (1993) ‘Promoting Competition in Hungary’, in C. T. Saunders (ed.), The Role of Competition in Economic Transition (New York: St. Martin’s Press), pp. 78–89. Rosenbaum, Eckehard F., Frank Bönker and Hans-Jürgen Wagener (eds) (2000) Privatization, Corporate Governance and the Emergence of Markets. Studies in Economic Transition (London: Macmillan). Rosenthal, Douglas E. and Mitsuo Matsushita (1997) ‘Competition in Japan and the West: Can the Approaches be Reconciled?’, in Edward M. Graham and J. David Richardson, Global Competition Policy (Washington DC: Institute for International Economics), pp. 313–38. Rubin, Paul H. (1993) ‘Private Mechanisms for the Creation of Efficient Institutions for Market Economies’, in László Somogyi (ed.), The Political Economy of the Transition Process in Eastern Europe (Aldershot: Edward Elgar), pp. 158–70. Sauvé, Pierre (1996) ‘Services and the International Contestability of Markets’, Transnational Corporations, vol. 5, no. 1, pp. 37–55. Scherer, F. M. (1994) Competition Policies for an Integrated World Economy (Washington, DC: Brookings Institution).

Ádám Török 145 Scherer, F. M. (1996) Industry Structure, Strategy and Public Policy College Publishers (New York: HarperCollins). Scherer, F. M. and David Ross (1990) Industrial Market Structure and Economic Performance (Boston, Mass.: Houghton Mifflin). Seade, Jesús (1995) ‘Competition and Trade Policy: Cooperation or Obligations’, International Business Lawyer, November, pp. 476–9. Slay, Ben (ed.) (1996) De-monopolization and Competition Policy in Post-Communist Economies (Boulder, CO: Westview Press). Somogyi, László (ed.) (1993) The Political Economy of the Transition Process in Eastern Europe (Aldershot: Edward Elgar). Török, Ádám (1996) ‘Competition Policy and De-monopolization in Hungary After 1990’, in Ben Slay (ed.), De-monopolization and Competition Policy in Post-Communist Economies (Boulder, CO: Westview Press), pp. 24–56. Török, Ádám (1997) ‘Competition Policy and Market Restructuring in the Hungarian Transition’, in Michael Fritsch and Hendrik Hansen (eds), Rules of Competition and East–West Integration (Boston, Dordrecht and London: Kluwer), pp. 125–47. Török, Ádám (1998) ‘Corporate Governance in the Transition – the Case of Hungary: Do New Structures Help Create Efficient Ownership Control?’, in László Halpern and Charles Wyplosz (eds), Hungary: Towards a Market Economy (Cambridge: Cambridge University Press and CEPR), pp. 159–91. Török, Ádám (2004) Is Merger Control too Lax in Transition Countries? (Research Series on European Integration) (Budapest: Prime Minister’s Office, forthcoming). Tóth, Levente (1998) ‘Aluszékony õrök’ (Sleepy guards), Figyelõ, 5 February, p. 50. UNCTAD (1995) World Investment Report. Transnational Corporations, Market Structure and Competition Policy (New York and Geneva: United Nations). UNCTAD (1997) World Investment Report. Transnational Corporations, Market Structure and Competition Policy (New York and Geneva: United Nations). UNCTAD (2000) World Investment Report 2000: Cross-Border Mergers and Acquisitions and Development. Country Fact Sheets, www.unctad.org/en/pub/ps4wir00fs.en.htm. Vissi, Ferenc (1993) ‘Hungary’s Experience of Competition Policy’, in Saul Estrin and Martin Cave (eds), Competition and Competition Policy. A Comparative Analysis of Central and Eastern Europe (London and New York: Pinter), pp. 20–7. Vissi, Ferenc (1995) ‘Versenypolitikai változások Magyarországon az Európa Megállapodás tükrében’, Külgazdaság, vol. 39, no. 10, pp. 4–16. World Bank (1996) From Plan to Market. World Development Report 1996 (New York: Oxford University Press).

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Part III The Economic Effects of Enlargement

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6 Consequences of Accession: Economic Effects on CEECs Michael A. Landesmann and Sándor Richter

Fiscal and financial aspects of accession to the EU: the issue of transfers The Copenhagen summit in December 2002 was one of the most important milestones in the long process of EU enlargement. The accession negotiations with the candidate countries (Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia) were concluded, and this opened the door for the final legal steps towards enlargement: the signing of the Accession Treaty and its ratification by the legislative bodies of the 15 current EU member countries, the European Parliament and the legislative bodies in the accession countries, subject to the results of referenda in each of the latter countries. At the beginning of the summit, of the 30 chapters to be negotiated only the chapters on Agriculture and Finance and Budget remained open. This was no coincidence as these two chapters had the most far-reaching financial implications for both present and future members of the EU. It was clear that the room for manoeuvre was rather limited and that the financial framework for new members laid down in 1999 in Berlin could not be enlarged. The stakes were high for the candidate countries. Would they be able to secure the maximum resources permitted under the 1999 Berlin framework for the first three years of membership? Would they return from the summit with results they could present to their constituents without loss of face? Would they be excused from being net contributors to the EU budget in the first three years of membership? Would agreement be reached on direct payments to farmers in the new member states that guaranteed fair competition with farmers in the old member states, once agricultural trade had been liberalized and the Common Agricultural Policy introduced in the new member countries? Transfers: the amounts The outcome of the long and hard negotiations in Copenhagen was that the total financial commitment for the ten new members for the three-year 149

150 Consequences of Accession

period 2004–6 amounted to €40.85 billion. This was less than the sum cited in the 1999 Berlin resolution – €42.59 billion – but somewhat more than that stipulated by the Commission’s Information Note of January 2002 – €40.16 billion (European Commission, 2002a). Interestingly that fact went more or less unnoticed as the immediate goal of the candidate countries had been to increase the financial commitments agreed at the Brussels summit in October. There, as a result of a German initiative, appropriations for structural actions in the new member states had been cut substantially. As a consequence the total financial package offered by the EU had dropped to €40 billion. In Copenhagen the prospective new members’ position improved considerably (by €800 million) in comparison with the last EU offer, which helped the EU and the applicant countries to sell the summit as a success, even though the final result was less favourable than that envisaged in the Berlin financial framework. For the applicant countries it was vital to ensure that they would avoid a net payer position in the first years of membership. As they were at a substantially less advanced stage of economic development than the incumbent countries, the idea that they should contribute more to the common budget than they received was unacceptable as any government that agreed to such an outcome would have been a sure loser at the next elections. Although the Commission declared several times that it would not require the new members to become net contributors to the budget, the candidate countries’ fear of this has been justified (see Richter, 2002). Contributions to the EU budget, termed ‘own resources’ (Table 6.1), can be predicted quite accurately (customs duties and agricultural levies, VAT-based resources and a GNP-based revenue component) (see European Commission, 1998, Annex 3, p. 5). Transfers from the EU budget, however, are much more uncertain. It is very important to distinguish between planned and actual transfers. Commitment appropriations and payment appropriations are both planning categories. The first consist of resources that are available in a given year to support EU cofinanced projects. The actual expenditure on individual projects does not necessarily start or end in that year. The second category, payment appropriations, consists of expenditure earmarked in a given year for ongoing EU cofinanced projects. This sum, however, is a far cry from what is actually disbursed, which to a large extent is dependent on the success or failure rate of applications for EU cofinanced projects. Transfers from the EU budget reach the target countries through a variety of channels. Some transfers are not project-related and can therefore be taken as real future disbursements. These include direct payments in a simplified version for new members, market interventions in agriculture, internal actions and additional expenditures. With other project-related transfers the sum disbursed in a given year is determined by the amount of EU cofinancing secured for individual projects. This group includes transfers

Table 6.1 Net budgetary positions of the new members after enlargement (payment appropriations), € million Cyprus 2003: Pre-accession aid 2004: Pre-accession aid Agriculture Structural actions Internal actions Additional expenditure Cash flow lump sum Budgetary compensation Total allocated expenditure Trad. own resources VAT resource GNP resource UK rebate Total own resources Net balance

Estonia

Hungary

Poland

Slovenia

Lithuania

Latvia

Slovakia

Malta

Total

16

170

55

197

844

45

115

84

123

11

1661

11 12 6 5 0 28 69 131

181 100 169 44 7 175 125 801

67 29 39 5 25 16 0 181

235 125 209 42 58 155 0 824

970 426 859 154 131 443 0 2983

51 43 27 12 38 65 30 267

127 73 94 11 84 35 0 423

99 42 66 10 28 19 0 264

120 57 118 19 21 63 0 398

7 3 7 2 0 12 38 70

1869 911 1594 305 392 1011 262 6343

⫺27 ⫺10 ⫺60 ⫺8 ⫺105 27

⫺66 ⫺74 ⫺426 ⫺56 ⫺623 178

⫺8 ⫺6 ⫺37 ⫺5 ⫺56 125

⫺97 ⫺61 ⫺349 ⫺46 ⫺554 270

⫺123 ⫺194 ⫺1114 ⫺148 ⫺1579 1404

⫺18 ⫺22 ⫺129 ⫺17 ⫺187 80

⫺22 ⫺14 ⫺78 ⫺10 ⫺124 299

⫺7 ⫺8 ⫺48 ⫺6 ⫺70 195

⫺33 ⫺26 ⫺148 ⫺20 ⫺225 173

⫺14 ⫺4 ⫺23 ⫺3 ⫺43 26

⫺415 ⫺420 ⫺2412 ⫺320 ⫺3566 2777

6 37 14 9 1 5 119 191

153 392 355 76 9 92 178 1255

57 82 88 9 26 3 0 266

199 544 438 72 61 28 0 1342

823 1512 1776 266 141 550 0 5068

43 125 59 21 38 18 66 370

110 228 203 18 109 6 0 674

86 116 151 17 29 3 0 402

102 205 244 33 52 11 0 647

2 8 13 4 0 27 66 119

1581 3248 3343 524 466 744 429 10 334

151

2005: Pre-accession aid Agriculture Structural actions Internal actions Additional expenditure Cash flow lump sum Budgetary compensation Total allocated expenditure

Czech Rep.

Trad. own resources VAT resource GNP resource UK rebate Total own resources Net balance 2006: Pre-accession aid Agriculture Structural actions Internal actions Additional expenditure Cash flow lump sum Budgetary compensation Total allocated expenditure Trad. own resources VAT resource GNP resource UK rebate Total own resources Net balance

152

Table 6.1 Continued Cyprus

Czech Rep.

Estonia

Hungary

Poland

Slovenia

Lithuania

Latvia

Slovakia

Malta

Total

⫺40 ⫺16 ⫺91 ⫺12 ⫺160

⫺105 ⫺116 ⫺653 ⫺88 ⫺963

⫺12 ⫺10 ⫺57 ⫺8 ⫺86

⫺150 ⫺95 ⫺535 ⫺72 ⫺853

⫺213 ⫺304 ⫺1707 ⫺230 ⫺2454

⫺29 ⫺35 ⫺198 ⫺27 ⫺288

⫺33 ⫺21 ⫺120 ⫺16 ⫺191

⫺11 ⫺13 ⫺74 ⫺10 ⫺107

⫺54 ⫺40 ⫺226 ⫺30 ⫺350

⫺21 ⫺6 ⫺35 ⫺5 ⫺66

⫺667 ⫺657 ⫺3697 ⫺497 ⫺5518

31

293

179

490

2614

82

483

295

297

53

4816

1 46 18 12 1 5 112 194

98 483 427 102 9 92 85 1294

35 102 110 12 26 3 0 288

124 653 524 97 61 28 0 1487

509 1934 2107 359 140 450 0 5498

27 158 73 28 38 18 36 378

66 294 248 25 127 6 0 766

52 156 189 22 28 3 0 451

64 260 289 45 52 11 0 720

0 10 15 5 0 27 63 121

976 4095 3998 708 481 644 296 11 198

⫺40 ⫺17 ⫺94 ⫺13 ⫺163

⫺105 ⫺119 ⫺670 ⫺93 ⫺988

⫺12 ⫺10 ⫺58 ⫺8 ⫺89

⫺150 ⫺97 ⫺549 ⫺77 ⫺873

⫺213 ⫺310 ⫺1752 ⫺244 ⫺2519

⫺29 ⫺36 ⫺203 ⫺28 ⫺296

⫺33 ⫺22 ⫺123 ⫺17 ⫺196

⫺11 ⫺13 ⫺76 ⫺11 ⫺110

⫺54 ⫺41 ⫺232 ⫺32 ⫺359

⫺21 ⫺6 ⫺36 ⫺5 ⫺68

⫺667 ⫺671 ⫺3793 ⫺529 ⫺5660

31

307

200

614

2979

82

570

341

361

53

5538

Note: In the event of a political settlement in Cyprus an additional amount of €127 million in payments is predicted for the three years 2004–6. Source: European Commission.

Michael A. Landesmann and Sándor Richter 153

from the Structural and Cohesion Funds, rural development transfers and the residual of preaccession aid. Project-related transfers require national cofinancing, typically 25 per cent for transfers from the Structural Funds, 15 per cent from the Cohesion Fund and 20 per cent for rural development. Hence project-related transfers are expensive compared with transfers of the other type, which do not call for national cofinancing. At the Copenhagen summit the candidate countries’ main goals were to increase the total sum of EU commitments and to increase the share of nonproject-related transfers in total transfers. While they had no real success with their first goal, they had much more luck with the second as neither the additional expenditure budgeted at the summit for strengthening the new Schengen borders nor the lump-sum transfers that would be made to avoid putting the new members in a net payer position were project-related. The partial redirection of rural development resources to top up direct payments to farmers was a further change that augmented the share of nonproject-related (and hence less risky and expensive) transfers. A special deal for Poland was the transfer of €1 billion from structural actions to unconditional lump-sum payments and project-related payments that would not require national cofinancing. The purpose of this deal was to reduce the budget deficit that would result from having to top up direct payments to Polish farmers. The Czech Republic managed to secure a similar deal worth €100 million. Will these changes be sufficient to prevent the new member countries from becoming net payers? In order to answer this question we have to assess the new members’ likely success rate where project-related resources are concerned. In this regard the European Commission’s Second Cohesion Report (2001a) provides helpful guidance. According to Table A.35 of that report, 72 per cent of the resources available in the period 1994–99 were in fact paid from the Structural Funds (Objectives 1, 2, 3 and 4) to the 15 EU members, and for the Cohesion Funds the project implementation rate in the last year of the financial framework (1999) ranged from 85 per cent (for Portugal, the best performer) to 65 per cent (for Greece, the weakest performer). Another factor should also be considered: for the incumbent countries, extensions from a previous financial framework have provided a financial buffer for the first two years of the subsequent financial framework – an opportunity that the new members will not be able to enjoy. Despite the above, one could arrive at a more pessimistic assessment using the same source. Between 1994 and 1999 some EU members’ success rate in acquiring transfers from the Structural Funds was disappointing, with Italy receiving about 51 per cent, Belgium 51 per cent and the UK 46 per cent. These figures could also serve as a reference for assessing the new members’ likely success rate. Of the €40.85 billion available for enlargement during the period 2004–6 as commitment appropriations, €27.88 billion will be budgeted as payment

154 Consequences of Accession

appropriations. Of the latter sum about 50–60 per cent will be projectrelated and 40–50 per cent non-project-related. In financial terms this amounts to €13.9–16.7 billion of project-related transfers and €11.2–13.9 billion of non-project-related transfers. The new members’ contribution to the EU budget will amount to approximately €14.7 billion. The sum of these figures, together with the estimated success/failure rate for project-related transfers, provide a basis for calculating the net financial position that the ten new members can expect as a group (the net position of individual members within the group may vary considerably). Assuming a success rate of 50 per cent at worst and 70 per cent at best1 for project-related transfers, the net flow to new members in 2004–6 will range from €5–10 billion,2 or €1.7–3.3 billion per annum, with a lower value in the first year and higher values in the third year. This will account for 0.4–0.8 per cent of the new members’ annual GDP, or 0.02–0.04 per cent of the annual aggregate GDP of the EU-15 in the same period. The expected net financial position of the new members can be viewed as the real cost of enlargement (in terms of budgetary transfers) to the 15 incumbent members of the EU for the first three years after enlargement. Contrary to widespread perceptions, these figures testify that the costs involved are negligible. Three remarks are in order here. First, the advantages of membership will not be restricted to the transfers discussed above. Indeed the gains from increased foreign direct investment, reduced transaction costs for trade, transport and industrial cooperation, and the opportunities offered by completely free access to the European market will be more significant than the net gains from transfers. Second, the balance of transfers will improve as time passes, with the balance in the third year being substantially better than those in the first and the second years. By the starting year of the new financial framework (2007) the phasing-in process will have been completed in respect of structural actions and will have progressed considerably in the area of direct payments. Third, the new members will participate in the discussions on the next financial framework (2007–13), so their ability to influence the distribution of expenditure will be much better than it was during the accession negotiations. If there is cause for concern for the present members about the costs of enlargement, then it will relate to the period 2007–13 and not 2004–6. The Copenhagen summit marked an important breakthrough in the longdebated issue of direct payments. The pre-Copenhagen offer by the EU to the candidate countries was to phase-in direct payments, starting with 25 per cent of the sum that their farmers would be entitled to receive in the event of full implementation of the Common Agricultural Policy (CAP) from day one of accession, rising to 30 per cent and 35 per cent in the second and third years respectively. This proposal was unacceptable to the candidate countries and they made a serious effort to raise the rates by arguing that the result would be distorted competition between farmers in the old

Michael A. Landesmann and Sándor Richter 155

member countries, who would enjoy full support, and farmers in the new member countries, who would have just one quarter of that support during the first year of membership. The candidate countries were also dissatisfied with the production quotas offered by the EU. Behind-the-scenes negotiations prior to the summit and intense talks at the summit resulted in substantially improved conditions for the candidate countries. With regard to direct payments, the initial rates were not raised but the new members would be entitled to top them up by 30 per cent from their national resources. Part of this top-up could be reallocated from resources earmarked for rural development, as long as the amount in question did not exceed 20 per cent of the total sum allocated to rural development. That solution would considerably improve the competitive power of farmers in the new member countries. A special solution was offered in principle to all candidates but in practice to Slovenia only. Any candidate country with an agricultural subsidy system comparable to the CAP could top up the EU payments with a sum from the national budget that corresponded to its 2003 level of national subsidies plus 10 per cent, provided that the 25 per cent from Brussels plus the national top-up did not exceed the amount that would be payable under the CAP when the phasing in of direct payment had been completed. For Slovenia, where subsidies (and the prices of factors of production) were similar to those in the EU (unlike in the other candidate countries, where subsidies were much lower), this promised a fair and easy transition to the CAP. In addition, in the final round of negotiations before the summit the production quotas allocated to the prospective new members were increased to some extent, so their production would not have to be cut back upon accession and in some areas there would even be room for increased output. Transfers: the impact Before addressing the economic impact that transfers will have on the new member countries’ economies, it is important to deal with the political implications. The agreement on transfers reached in Copenhagen was the outcome of a very difficult bargaining process. It was a compromise, and one that was far from satisfactory for the prospective new member countries as it could not be held up as a success in the domestic political arena. Nevertheless it was not an unacceptable outcome and in the short run this will outweigh other considerations. If the negotiations had resulted in a negative net financial position, or if national top-ups of direct payments had not been agreed, in all likelihood the governments in question would not have been able to sell the idea of EU membership to their legislative bodies or their voters. Turning now to the economic impact of the transfers, at first glance, it seems that the impact will be negligible. The additional resources of €5–10 billion for the 10 new members over a period of three years can be

156 Consequences of Accession

compared, though with some qualifications, with a probable FDI inflow of €52 billion, as forecast by the Vienna Institute for International Economic Studies for the prospective new EU members (without Cyprus and Malta) in the final three preaccession years (2001–3). The qualifications refer to the difference in prices (transfers, 1999 prices; FDI, current prices) and to the fact that the prospective new members are also sources of outward FDI. Subtracting the sum of €3 billion for the three years concerned3 we arrive at a net FDI inflow of €49 billion, which is five to ten times larger than the estimated net inflow of EU transfers in the years concerned. Compared in another way, the cumulative current account deficit of the Central European applicant countries (excluding the Baltic states) is expected to amount to about €45 billion over the same period. Although calculating the balance of transfers to and from the EU budget provides valuable information on the magnitude of the additional financial resources that will be available to the new member economies as a result of accession to the EU, the ‘net position’ approach is unsuitable for assessing the impact of EU transfers on their economies. The transfers to and from the EU budget will affect different segments of the economy, thus causing significant variations in individual sectors. Cohesion Fund transfers will make up about one third of total structural actions (transfers from the Structural Funds and the Cohesion Fund) and 11 per cent of total payment appropriations for the period 2004–6. An important feature of these transfers is that they will be absorbed by the national budgets. Depending on the success rate with the projects involved, Cohesion Fund transfers will create an additional revenue of 0.11–0.15 per cent of the applicants’ GDP (after deducting 15 per cent national cofinancing). This is modest in macroeconomic terms, but at the level of public investment in the environment and transportation infrastructure the impact will be considerable. Structural Fund transfers will help to finance projects in education and training, infrastructure and the enterprise sector. Here the revenue side will be much less concentrated than in the case of Cohesion Fund transfers, as the main recipients will be regions and regional projects. Again, while the additional financing will be negligible in national terms the impact will be significant at the regional, subregional and local levels, and for a limited group of activities (for example a new institution of higher education in a certain discipline, and so on). All this relates to transfers for rural development and the residual from preaccession aid. For the sake of comparison, recall that transfers from the Structural Funds to the four cohesion countries accounted for 5.5 per cent of fixed capital formation in 1989–93, 8.9 per cent in 1994–99 and will probably reach about 7 per cent in 2000–6. The shares have been especially high (between 11.4 per cent and 14.6 per cent) in Greece and Portugal (see Lolos, 2001). Due to the phasing in of payments and likely difficulties with absorption in

Michael A. Landesmann and Sándor Richter 157

the first years of membership, these shares will probably account for less than 5 per cent of fixed capital formation in the new member countries. All project-related transfers will require national cofinancing. Whether this will involve additional expenditure from the national budget, whether budgeted items will obtain additional external financing through EU transfers or whether existing national structural expenditure will be replaced by EU resources are questions that cannot be answered in general terms as the situation may differ from item to item. It will be permitted to use Cohesion Fund transfers to finance ongoing programmes, while the ‘additionality principle’ attached to Structural Fund transfers will require the level of public investment in the recipient country to be maintained, based on a past reference period. This means that national structural spending cannot be reduced but can be restructured to cover cofinancing needs (see Backé, 2002, p. 153). Restructuring expenditure along these lines could lead to serious problems in areas that lose from the process: those which receive less support than before owing to the cofinancing of projects in preferred areas supported by transfers from the EU. At first this issue is unlikely to be very important given the low initial level of transfers, but as the phasing in period progresses and the transfers increase, it could become a significant source of conflict. Direct payments to farmers are a specific form of transfer that replace national agricultural subsidy systems and thus reduce the overall national budget expenditure. For the new members this will not be simple. As discussed earlier, in a last-minute concession at the Copenhagen summit the prospective new members were granted the right to pay top-ups to their farmers from the national budget. This will have conflicting effects. On the one hand the competitive position of farmers in these countries will improve considerably during the first years of membership. On the other hand the national budgets will be presented with a large additional burden. The new member states will have to contribute to the EU budget to pay for the direct payments, but the expenditure side of their national budget will know no relief as expenditure will remain more or less at the preaccession level as a result of the top-ups. In sum it is obvious that the new members’ national budgets will feel the impact of transfers to and from the EU. Things are relatively more simple where ‘own resources’ are concerned: an item of expenditure equivalent to about 1.1 per cent of GDP can be safely assessed. On the revenue side, however, the impact is much more difficult to assess owing to the unpredictable value of inflows to project-related items. For reasons mentioned earlier it is also difficult to estimate the expenditure required to cover cofinancing requirements. Prior to the Copenhagen summit Backé (2002, p. 155) assessed the likely impact of transfers from the Structural and Cohesion Funds. He estimated that the fiscal impact could range from ⫺0.9 per cent to ⫹1.3 per cent of the new members’ GDP. The message here is that the overall impact may be negative

158 Consequences of Accession

or positive, but either way it will be moderate. However this moderate overall impact may mask quite substantial partial changes and radical restructuring of individual sections of the budget, and the work involved in managing these changes should not be underestimated. It should be noted that transfers are only one aspect of the budgetary implications of EU accession. The costs of complying with the acquis communautaire (especially with regard to environmental protection), phasing out production subsidies, harmonizing taxation and reducing risk premia in financing on the one hand, and the positive growth effects deriving from EU membership on the other, will significantly affect the new members’ national budgets.4 Transfers in the enlarged EU after 2006 The forthcoming enlargement will substantially alter the composition of the EU in terms of its members’ economic strength. The six original members (France, Germany, Italy and the Benelux countries) were at similar levels of economic development. That situation changed after the first enlargement and the entry of Ireland, whose economy lagged substantially behind the average. The number of laggards increased to two when Greece joined in 1981 and four when Spain and Portugal became members in 1986. The eight to four ratio of ‘rich’ and ‘poor’ members changed to eleven to four after the most recent enlargement (1995). Due to Ireland’s exceptionally rapid economic growth in the past decade, this country has caught up with the highly developed group and now even exceeds the EU-15 average. By 2007 the ratio for the present 15 members will be twelve to three, with Greece, Portugal and Spain still well below the average level of development. Resources drawn from the EU budget to reduce the differences between the member countries’ levels of economic development (that is, to foster cohesion) are limited to 0.45 per cent of the EU’s GDP until 2006, as decided by the Berlin Council in 1999. Moreover transfers for structural projects must not exceed 4 per cent of the GDP of any recipient country in any year. Despite the fact that in three successive financial planning periods (1989–93, 1994–99 and 2000–6) per capita transfers were increased from €143 to €187 and €217 (see European Commission, 2002c, p. 6), and bearing in mind the hard bargaining during the accession negotiations, it is difficult to imagine that in the next planning period (2007–13) either of the 0.45 per cent and 4 per cent limits will be raised. This means that the bargaining for the redistribution of resources will be more difficult than ever. The accession of the new members will increase the EU’s aggregate GDP by about 5 per cent, with an accordingly modest contribution to the EU budget. Thus the resources available for redistribution will barely increase but the claims for transfers by potential recipients will be substantially higher as the gap between the levels of economic development of the member states above the EU average and those below the EU average will be much wider in the EU-25 than it was in the EU-15.

Michael A. Landesmann and Sándor Richter 159

In light of the above some EU regions that to date have been eligible for structural support will no longer be so if the present rules continue to prevail. The worst losers among the present member states will be Greece, Portugal and Spain. In order to minimize the shock caused by the cessation of structural support the European Commission (2001a, p. xxxiv) has recommended the following alternative solutions: ●

●

●

●

Maintain the threshold of 75 per cent of the EU average as the criterion for eligibility for support in the enlarged EU, but provide support to regions outside the least developed areas through a separate set of priorities and criteria. Maintain the 75 per cent threshold but (1) provide temporary support to EU-15 regions that from 2006 onwards will no longer be classified as laggards, and (2) provide a higher level of support to regions that would have remained below the 75 per cent threshold in the absence of enlargement. Set the threshold higher than 75 per cent to prevent the automatic exclusion of countries that will be affected by the lower EU average after enlargement. Fix two thresholds of eligibility, one for regions in the present EU-15 and one for the new members.

While all but the last solution5 would be technically suitable, a fundamental problem will remain: with a given volume of resources available for redistribution, the old and new members will be competing for the same stakes. Moreover there will be a conflict between (1) avoiding a drastic reduction of structural support to member states whose gap with the EU average has not closed in real economic terms but will close in statistical terms after enlargement; and (2) adhering to the essence of cohesion policy, that is, focusing structural support on the least developed EU regions. The problems of redistribution will not be confined to the present EU members. The disparities between the new members’ levels of economic development will continue to be considerable and will grow further when Bulgaria and Romania join the EU, perhaps as soon as 2007 (see Table 6.2). In its first progress report the Commission (2002c, p. A-13) categorizes three groups of countries in an EU of 27 member countries. The first group consists of 12 ‘rich’ members of the present EU-15, defined as having an average level of development of about 20 per cent above the average of the EU-27 (at PPS in year 2000). The second group comprises three members of the present EU-15 (Greece, Portugal and Spain) and the three most developed accession countries (the Czech Republic, Cyprus and Slovenia), which as a group stand at 87 per cent of the EU-27 average level of economic development. The third group consists of the remaining applicant countries whose group developmental average is about 41 per cent of the EU-27 average (ibid., p. 9).

160 Table 6.2 Per capita GDP in selected countries at current PPPs (euro/ECU) and constant PPPs from 2003 1995

2004

2007

2013

11 281 8236 6302 8235 11 607 5927 4407 5235 14 150 9330 5004 5768 11 924 12 840 19 937 19 890 18 182 16 382 15 677

15 628 13 634 10 302 13 426 18 441 11 774 9127 10 393 22 980 14 406 8453 6603 17 906 18 937 27 420 25 869 25 204 23 038 22 037

17 580 15 336 11 588 15 102 20 744 13 245 10 267 11 691 25 850 16 205 9520 7472 20 142 21 301 29 098 27 452 26 812 24 630 23 584

22 244 19 406 14 663 19 109 26 247 16 759 12 990 14 792 32 708 20 505 12 046 9398 25 486 26 953 32 769 30 916 30 355 28 183 27 046

Relative position (EU-15 average ⫽ 100): Czech Republic 62 Hungary 45 Poland 35 Slovak Republic 45 Slovenia 64 Estonia 33 Latvia 24 Lithuania 29 Cyprus 78 Malta 51 Bulgaria 28 Romania 32 Greece 66 Portugal 71 Austria 110 Germany 109

62 54 41 53 73 47 36 41 91 57 34 26 71 75 109 103

66 57 43 56 77 49 38 44 96 60 36 28 75 79 109 102

73 64 48 63 86 55 43 49 108 68 40 31 84 89 108 102

Relative position (EU-25 average ⫽ 100): Czech Republic 69 Hungary 50 Poland 38 Slovak Republic 50 Slovenia 71 Estonia 36 Latvia 27 Lithuania 32 Cyprus 86

68 59 45 58 80 51 40 45 100

71 62 47 61 84 54 42 47 105

79 69 52 68 93 59 46 52 116

Czech Republic1 Hungary1 Poland1 Slovak Republic1 Slovenia1 Estonia1 Latvia1 Lithuania1 Cyprus1 Malta1 Bulgaria1 Romania1 Greece1 Portugal1 Austria2 Germany2 EU-15 average EU-25 average EU-27 average

Michael A. Landesmann and Sándor Richter 161 Table 6.2 Continued

Malta Bulgaria Romania Greece Portugal Austria Germany

1995

2004

2007

2013

57 31 35 73 78 122 121

63 37 29 78 82 119 112

66 39 30 82 86 118 111

73 43 33 90 96 116 110

71 62 47 61 84 53 41 47 104 65 38 30 81 86 124 117

75 65 49 64 88 56 44 50 110 69 40 31 85 90 123 116

82 72 54 71 97 62 48 55 121 76 45 35 94 100 121 114

Relative position (EU-27 average ⫽ 100): Czech Republic 72 Hungary 53 Poland 40 Slovak Republic 53 Slovenia 74 Estonia 38 Latvia 28 Lithuania 33 Cyprus 90 Malta 60 Bulgaria 32 Romania 37 Greece 76 Portugal 82 Austria 127 Germany 127

Notes 1. The projections for 2007 and 2013 assume an annual GDP growth of 4 per cent and zero population growth. 2. The projections for 2007 and 2013 assume an annual GDP growth of 2 per cent and zero population growth. Sources: OECD (1999, 2002); national statistics; WIFO; WIIW; OECD Economic Outlook statistics.

If the philosophy of solidarity were taken to its extreme, structural support should be concentrated in the least developed regions. Table 6.3 shows the likely consequences in 2007. Working on the assumptions that (1) 0.45 per cent of EU GDP will continue to be used to finance structural projects, (2) no member may receive transfers that amount to more than 4 per cent of its GDP in the framework of structural actions, and (3) the allocation starts with ‘full satisfaction’ of the least developed EU members (only after they have reached their ceiling for transfers will resources be allocated to the next least developed members), the results are as follows. In the EU-25 the group of least developed new members – the Baltic states and Poland – are likely to absorb 41 per cent of the total resources available for structural actions. If all the other new members were added (except for Slovenia and Cyprus, which are at more or less the same level of development as Greece, Portugal and Spain) they would absorb 75 per cent. If this

162 Consequences of Accession Table 6.3 Hypothetical share of groups of new EU members in transfers from the Structural Funds and the Cohesion Fund, 2007 (per cent)1

Maximum share of total available resources for structural actions by the EU-25 in 2007 Maximum share of total available resources for structural actions by the EU-27 in 2007

Group A ⫽ three Baltic states and Poland 2

Group B ⫽ Group A plus Hungary and Slovakia

Group C ⫽ Group B plus Czech Rep. and Malta

Group D ⫽ Group C plus Cyprus and Slovenia

41

60

75

79

59

77

91

96

Notes 1. The basic assumptions are as follows: 0.45 per cent of EU GDP will be available for structural actions, and transfers within the framework of structural actions will reach the maximum permitted level of 4 per cent of GDP. 2. Plus Bulgaria and Romania for the EU-27 figure. Source: Data from Table 6.2.

were translated into the situation in 2003, Greece, Portugal and Spain would be able to claim 113 per cent of the available resources (0.45 per cent of EU-15 GDP) for structural actions if they had the opportunity to receive transfers of up to 4 per cent of their GDP. The picture would differ substantially in the EU-27 in 2007, assuming that the bloc of least developed countries – Bulgaria, Romania, the Baltic countries and Poland – received, under the same conditions, 59 per cent of the available resources. This exercise shows that the relatively more developed new members, particularly Hungary and Slovakia but also the Czech Republic and Malta, will be in a substantially worse position in the bargaining process in an EU with 27 members than they would be if there were 25. Obviously it is not feasible that the new members will receive nearly all the available resources, and the maximum assistance for the least developed new members already consumes nearly two thirds of the total available resources. The Czech Republic, Hungary and Slovakia will probably have to share the remaining one third with the ‘rich’ new members (Slovenia and Cyprus), the former cohesion countries and some highly developed members with a few underdeveloped regions. The strong concentration of transfers from the Structural Funds and the Cohesion Fund would probably reduce the motivation of countries that did not benefit or only marginally benefited from the redistribution of resources in the enlarged EU. It should be recalled that structural support has always had a dual function in the EU: (1) to reduce disparities in development at

Michael A. Landesmann and Sándor Richter 163

the national and regional levels, and (2) to facilitate the integration process and strengthen sectoral policies and institutional development. ‘Broadly speaking this is because the structural and cohesion funds have functioned as a pool of money that could be deployed in order to remove political obstacles on the road to integration. Expressed in a cruder fashion: to buy out countries that otherwise would refuse to participate in the one or other reform process’ (Tarschys, 2000).6 In 1999, of the 11 rich EU member states (that is, the EU-15 minus the cohesion countries) seven had at least one but typically more Objective 1 regions with a development level below 75 per cent of the EU average.7 As Karlsson (2002, p. 63) points out, the availability of EU transfers for local projects helped to reduce the member countries’ prejudice against ‘the bureaucracy in Brussels’. The main task under the new financial framework will be to find a balance between the two functions of structural actions: to diminish regional disparities by concentrating resources in the least developed countries/ regions, and to facilitate cohesion in the entire bloc. This task will be made even more difficult by the fact that the own-resources ceiling must be observed, that is, the extent of redistribution cannot be increased. More resources for structural actions could be made available through radical reform of the CAP, but such a move is improbable. A further question is whether the instruments used to reduce the relatively small disparities between the present EU-15 will be suitable to treat problems in countries/regions with a wide gap relative to the EU average. Reforms in this area could lead to complete restructuring and a new philosophy of structural actions in the enlarged EU, although the disparity between the interests of various country groups would not disappear. It would, however, be easier to address the related problems within the framework of an overall reform instead of trying to adjust the existing distribution schemes to a situation that included fundamental changes. In the debate on enlargement it has often been stated that accession has already taken place at the level of trade and FDI. With regard to the redistributive aspects of European integration, we can stand this statement on its head and point out that enlargement can only be considered to be complete once the new financial framework has been signed by all members in 2006.

Macroeconomic implications of EU membership for the candidate countries This section continues to discuss the implications of EU membership for the conduct of macroeconomic policy, but it takes a wider view than the previous section. An extensive amount of research has been conducted on the macroeconomic policy challenges that the CEECs will encounter in the wake of EU accession. Much of the research has focused on the implications of choosing certain exchange rate regimes, and in particular on the issue of the time horizon of EMU membership and the situation the new members

164 Consequences of Accession

will face prior to full EMU membership. In this section we shall consider the monetary and exchange rate policy challenges faced by the new member countries, as well as some fiscal policy challenges. In the subsequent section we shall discuss the long-term growth and catching-up prospects of the new member countries. As Figures 6.1 and 6.2 illustrate, in general there has been an impressive reduction in the candidate countries’ inflation rates and nominal interest 25

20

15

10

5

0 1996

1997

Czech Republic

1998

1999

Hungary

2000 Poland

2001 Slovakia

2002 EU-15

25

20

15

10

5

0 1996

1997

Slovenia

1998 Estonia

1999 Latvia

2000

2001 Lithuania

2002 EU-15

Figure 6.1 GDP deflator, 1996–2002 (percentage change from previous year) Sources: WIIW Database; OECD.

Michael A. Landesmann and Sándor Richter 165 25

20

15

10

5

0 1998 Czech Republic

1999 Poland

2000 Hungary

2001 Slovakia

2002 Euro area

20

16

12

8

4

0 1998 Slovenia

1999 Estonia

2000 Latvia

2001

2002

Lithuania

Euro area

Figure 6.2 Interest rates, 1998–2002 (nominal NB leading rate, per cent per annum) Notes: Estonia: 1-month Talibor interbank rate. Lithuania: 1-month Vilibor interbank rate. Euro area: interest rate for main financing operations. Sources: WIIW; ECB.

rates, although with some exceptions they still hover above the EU average (we shall return to the issue of nominal convergence later). With regard to assessing the fragility of the system of financial intermediation, at different points most of the transition economies have gone through a dramatic process of bank restructuring. In the early years of transition, adverse

166 Consequences of Accession

conditions in their banking systems (linked mostly to stalemates in the process of corporate restructuring) led to serious disruptions to growth or to outright recessions. By the late 1990s/early 2000s conditions were much improved and in all the first-round accession countries (Slovenia was a laggard in this respect until very recently) a now substantial segment of the banking system is owned by foreign banks. From a balance-sheet point of view this implies that their banking systems are in a much better shape than they were in the 1990s. However the degree of financial intermediation in these countries is much lower than in the EU-15 and some features of thin and imperfect capital markets persist (for example small and medium-sized enterprises have difficulty obtaining credit), so in these areas substantial progress is still required. On the fiscal side, too, the situation remains problematic. The fiscal situation in some of the economies in question is still out of line with EU macroeconomic guidelines, which aim at fiscal balance over a full cycle; the fiscal deficits in quite a few of the candidate countries continue to exceed the 3 per cent deficit limit (Figure 6.3). There are strong arguments that the application of these guidelines to the candidate countries is misplaced (see Buiter and Grafe, 2003). The reasons for this are twofold. First, from the point of view of ‘fiscal sustainability’ it is inappropriate to neglect differences in their structural characteristics and expected growth rates. In this respect it is clear from analyses of what constitutes a sustainable debt/GDP situation that economies with different initial debt levels (which are relatively low in the candidates countries) or different prospective trend growth rates (and in principle, different demographic profiles) will have different public deficit to GDP ratios in the medium term. Second, there are still transition tasks to be completed, as well as developmental catching up and de facto integration with the EU. The candidate countries have to shoulder the substantial burden of ex ante investments to overhaul their outdated capital stock, bring their environmental protection levels into line with those in the EU, finance the reorientation of educational and training institutions to meet the requirements of a catching-up market economy, build up infrastructural facilities, support the institutional changes that have to be completed to comply with the acquis and so on. In all the above respects there is an argument in favour of intergenerational equity, that is, the burden of these investments should be carried not only by the current generation but also by future generations that will benefit from the increased productivity and income levels that the investments will bring. This implies the build-up of some degree of public debt, but this must remain within the bounds of fiscal sustainability and should not give rise to crisis situations. As strict adherence to the zero deficit criterion over the business cycle is linked to EMU membership, a decision in favour of early EMU membership would impose this criterion on fiscal policy. This would, however, be inconsistent with the views set out above.

Michael A. Landesmann and Sándor Richter 167 2 0 –2 –4 –6 –8 –10 1998

1999

Czech Republic

Hungary

2000 Poland

2001 Slovakia

2002 EU-15

2 1 0 –1 –2 –3 –4 –5 1998

1999

Slovenia

Estonia

2000 Latvia

2001 Lithuania

2002 EU-15

Figure 6.3 Budget balance, 1998–2002 (percentage of GDP) Sources: WIIW Database; OECD.

All the above are medium- to long-term measures to adjust the deficit and debt criteria in the light of the specific circumstances of the new member countries, but one should not forget that there will be problems with macroeconomic stability in the short term. There is a danger that these countries will suffer more from volatile movements in the public deficit to GDP ratios, with a consequent impact on interest rates and the financial markets more

168 Consequences of Accession

generally, than the more mature EU economies. Analysis of the volatility of the growth rates of catching-up economies in general and transition economies in particular show that cyclical volatility is more pronounced in these economies (see Azariadis, forthcoming). This brings with it the danger that the deficit to GDP ratio will move outside the corridor indicated by the Maastricht criteria or the threshold beyond which international financial markets react detrimentally. This would negatively affect the public and private sectors in terms of higher interest rates and bring about a deterioration in credit ratings. The volatility of the business cycle and the possibility that structurally the accession countries are vulnerable to internal and external shocks8 points to the need for a countercyclical policy, plus a longer-term fiscal-deficit target that will allow strong responses to downturns without moving into danger zones which prompt negative reactions by the financial markets. In general the accession countries will continue to make extensive structural adjustments after joining the EU; this may often contribute to macroeconomic volatility and therefore they will continue to be in a vulnerable position. It follows that while the long-term sustainability of the fiscal situation should be the main consideration in fiscal planning, in the short-term public deficits will require close monitoring. Rigid fiscal policy guidelines that ignore the specific situations in which the accession countries find themselves will not be conducive to their catching-up efforts. Fiscal policy should be designed to facilitate a smooth growth process. While this view is shared by most economists there is disagreement about the type of fiscal policy arrangement that is most likely to bring about this end. There is also disagreement among economists and policy makers about reform of the Growth and Stability Pact (for example see Wyplosz, 2002). Some suggest that there should be a stronger focus on economically justifiable criteria for fiscal sustainability than on flow criteria (the year-by-year deficit to GDP target), with an emphasis on types of public expenditure that will strengthen the long-term productive potential of economies (and hence their growth path), rather than on purely consumption expenditures. The debate on reform of the Growth and Stability Pact will no doubt intensify with the accession of the new members, as at that point the range of EU countries with different structural characteristics and growth rates will widen. Upon accession the new member countries will participate in the EU’s economic and fiscal policy coordination and surveillance framework (the broad economic policy guidelines, BEPG, and the Stability and Growth Pact). The Stability and Growth Pact obliges member countries to remain below the 3 per cent fiscal-deficit limit during normal economic downturns – for outright recessions the pact’s rules include escape clauses. Prior to EMU membership the new members will be required to present annual convergence programmes to the Commission and the Council of Ministers, and they will be expected to follow the annual recommendations of the Council in

Michael A. Landesmann and Sándor Richter 169

relation to the BEPGs. During that time no sanctioning mechanisms will be applied in the event of failure to follow the BEPG recommendations, but the pressure to conform will be quite substantial. Given the difficulty of reaching agreement at the EU level on reform of the present policy frameworks, the new member countries will have to comply with these frameworks and conform to tighter fiscal policy guidelines than they are used to. While this will no doubt result in serious attempts to tackle issues that could endanger fiscal sustainability (such as social security reforms), analysts believe that this could be to the detriment of growth and the catching-up process. Exchange rate policy and the timing of EMU entry are complex issues and so far economists have not reached a common position. Quite a few of the arguments discussed above in respect of fiscal policy also apply to exchange rate policy. The aim is to construct a framework in which ‘smooth’ and sustainable growth can be achieved. The traditional approach to the question of when a country should join a monetary union is to ask whether it can meet the so-called OCA (optimum currency area) criteria. These criteria have been set up to judge whether the costs of losing sovereignty over certain policy instruments (exchange rates and monetary policy) are outweighed by the benefits of participating in a currency union (lower transaction costs, lower volatility in an important set of prices, in particular stable exchange rates with the main trading partners, potentially lower interest rates due to the greater credibility of a centralized monetary policy, potentially lower inflation rates, less danger of destabilizing capital flows and so on). The OCA criteria include the degree to which a particular country is prone to asymmetric shocks in relation to the other countries in the monetary union (this can be judged by examining synchronicity of past business cycles, by whether production structures have become sufficiently diversified and have converged, and by whether there is a strong intercountry transmission mechanisms of shocks through trade, FDI and other linkages), and the manner in which it responds to such shocks (through adjustments in product and labour markets, the latter including the interregional and intercountry mobility of labour). Fulfilment of these criteria relative to other countries has always been the basis for judging whether a country (and the other members) would enjoy net benefits from joining a currency union or whether a currency union should be set up in the first place. Many studies have shown that when a currency union is formed it is likely to include countries that – at the time of joining – do not fulfil the OCA criteria. One reason for this could be that political considerations override the narrow economic criteria considered in OCA analyses. Another approach that has recently gained popularity focuses on the endogeneity of OCA criteria fulfilment (see Frankel and Rose, 2002). Here ‘endogeneity’ refers to the situation in which the OCA criteria are not fulfilled by a country

170 Consequences of Accession

when it is outside a currency union, but when it joins certain processes are set in motion that make it likely that the criteria will be fulfilled ex post. From an a priori theoretical standpoint there are strong grounds for believing in this proposition: by lowering transaction costs and removing exchange rate volatility among the main trading partners, the latter will intensify their trade links and integrate their production. This will lead to a strengthening of the transmission of shocks and hence to greater synchronicity of the business cycle. On the other hand, some observers have argued (based on traditional trade theory – see Krugman, 1993) that trade intensification can result in more pronounced patterns of specialization, thus increasing the likelihood of asymmetric shocks. More recent analyses, however, have found that over time tighter integration leads to developmental convergence, to more intra-industry trade and to horizontal rather than vertical production differentiation and integration. In the particular case of EU/EMU integration there is the additional, very important fact that we are dealing with a union that is characterized by ‘deep integration’ (Lawrence, 1996). It is more than a customs and currency union as it has unified a number of other central areas of policy making (such as competition policy, regional policy, some aspects of social policy, fiscal policy and so on), and has moved a long way towards the integration of product markets, capital markets and – though somewhat less successfully – labour markets. This has resulted in the faster transmission of shocks, the synchronization of business cycles and of policy responses to such cycles. Against this background, it must be remembered that the accession countries are still at a substantially lower level of economic development (as measured by per capita income and productivity levels) and still in the process of making fundamental structural adjustments (related partly to remnants of the transition process and partly to the developmental and catching-up processes). Thus while membership of a union where ‘deep integration’ is a very important feature will no doubt speed up their convergence and integration, this will nonetheless take time. Furthermore economic integration is itself the cause of sometimes dramatic adjustment pressures that require a policy framework to deal with such pressures in a (welfare) efficient manner. Hence the question arises as to the point at which the step towards full currency union should be taken, with all the obligations that entails in a wide range of policy-making areas. Here the views of economists in the accession countries and the EU-15 are still at odds. Two additional considerations have been brought into the picture in the current debate on the timing of EMU entry: one has to do with the nature of full capital market integration and the possibility of destabilizing movements of capital, and the other refers to the well-known Balassa–Samuelson hypothesis with respect to price level convergence between economies as the catching-up process proceeds. With regard to the first issue, the potential danger of destabilizing capital flows in the context of strong capital market integration, an influential

Michael A. Landesmann and Sándor Richter 171

study by Begg et al. (2002) contains an extensive evaluation of international experiences of various exchange rate regimes. In the context of EU accession, full capital market liberalization is part of the acquis, and no exemptions were requested by the candidate countries during the accession negotiations (except for regulations on the acquisition of land). Hence the conditions of full capital market liberalization have to be adhered to and the conduct of economic policy adjusted to it. In our opinion, however, the regime switch required in this respect will not be as drastic as some commentators suggest. The accession countries have already largely liberalized their capital transactions with the EU. Hence the pressures under which the fiscal and monetary authorities have had to operate over the past few years, and which they have mastered with varying degrees of success, are more or less in line with what can be expected after accession. Nonetheless it must be acknowledged that the accession countries’ financial systems are still more fragile than those of the EU-15, and this, together with the remaining interest rate differentials, will increase the attractiveness of borrowing from abroad. However, the danger of unduly large capital inflows and outflows would be just as great if the accession countries adopted overly ambitious targets for bringing their inflation rates into line with those of the core EU members and introduced a fixed exchange rate regime that turned out to be unsustainable. This is the lesson that has been learnt from numerous experiences in Central and Eastern Europe as well as internationally over the last decade and a half. In light of the above, a visible effort to utilize the allowable degrees of freedom under the ERM regime (which most of the accession countries will join upon entry to the EU) in relation to targets that are both attainable and sustainable will send the right signals to international financial markets. A mix of policy instruments (inflation targeting, fiscal policy and growthenhancing policies) should be employed in such a way that the individual countries will be seen as working in harmony rather than in-conflict with the aim to achieve smooth growth. Full EMU entry should follow a period of alleviating structural adjustment pressures within a policy framework which maintains some degree of flexibility. After all the Maastricht criteria for EMU entry are designed to show that candidate countries are able to fulfil the criteria of nominal convergence and fiscal stability on a sustained rather than a temporary basis. Tests based on the Balassa–Samuelson (B–S) hypothesis are often used to analyse price convergence processes and whether these conflict with the EMU criteria. Such analyses are based on the differences between more advanced and less advanced economies in terms of relative productivity levels in the tradable and non-tradable sectors. Given the assumptions that small open economies are price takers in the tradable sector, that workers receive as wages their marginal products and that the labour force is mobile across sectors, differential catching up in productivity in the tradable goods sector (where the initial productivity gaps are assumed to be high) pushes

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up relative prices in the non-tradable sector and hence the overall price level in the catching-up economy. This leads to a real appreciation of the currency, either through a higher inflation rate and/or appreciation of the nominal exchange rate. Figure 6.4 shows that there has been a substantial real appreciation of the currencies of most of the accession countries in relation to the euro. A number of other studies have produced similar findings (see in particular Halpern and Wyplosz, 1997, 2001; for an overview of relevant studies see European Commission, 2002e, ch. 5). Moreover there is likely to be substantial real exchange rate appreciation after accession, which is a strong argument against early membership of EMU. Under the EMU membership rules, prospective members must maintain nominal exchange rate stability in relation to the euro over a sustained period while at the same time keeping their inflation rates close to those of low-inflation EMU members. These requirements obviously conflict with a significant B–S process, so as long as the EMU accession rules are not changed a significant B–S process will prevent EMU entry. A number of analysts have argued that the scope for a further B–S process for the accession countries has been overestimated (see for example Coricelli and Jazbec, 2001; European Commission, 2002e, ch. 5). They argue that using past time series data to predict future trends produces a misleading picture as some of the data relate to the early period in which the strongly distorted price structures inherited from the planned economy had yet to be adjusted (think of the many highly subsidized areas, especially in the nontradable sector, such as rents, public transport and so on). Decomposition of relative price structure changes into a component that reflects the adjustment of relative prices from a distorted planned economy to a market environment produces much lower, although still substantial estimates of the B–S adjustment process. Our own view is that the adjustment process in relative price structures due to past ‘distortions’ is still not a completed process (there are substantial adjustments still to be expected in many CEECs in rental markets, in public transport, in health, etc.) and this adjustment will continue to play a role in the future; furthermore, productivity level comparisons still show very substantial productivity gaps between in the tradable sectors in the accession countries and the EU-15 (WIIW, 2003), and that productivity catching-up is very uneven across the various sectors of the economy (Landesmann, 2000; Landesmann and Stehrer, 2002). There is therefore substantial scope for the B–S process to take place. This provides a strong argument for either delaying EMU accession or changing the accession rules. ERM entry, however, would be feasible as it would allow adjustments to be made to the central parity rates by common agreement. We now return to the issue of whether early EMU entry would positively or negatively affect macroeconomic stability in the accession countries (for a discussion of these issues see Begg et al., 2002). There is no agreement on

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this issue. Those who advocate early entry base their arguments on the idea that it would provide a safeguard against potentially destabilizing inflows and outflows of capital, which – even if the fundamental policies pursued were sound – would lead to exchange rate crises. In conditions of fully liberalized capital movements (the acquis does not allow any restrictions in this respect) destabilizing capital movements could not be prevented and, it is argued, would almost of necessity take place as markets put the final phase to the test before an irreversible exchange rate was fixed. Another question is whether the accession countries will be able to give up the safety valve of exchange rate adjustments if they move into unsustainable current account positions. We have seen in the past that CEECs have not been able to sustain a fixed peg (with the exception of Bulgaria and Estonia, which adopted a strict currency board regime). Such arrangements led to major exchange rate crises that entailed exchange rate realignments (the Czech Republic in 1997, the Slovak Republic in 1999, Poland in 2002 and so on). While opinions differ in this respect, many economists argue (as do the European Commission and the ECB) that it would be premature, given events over the past few years, to be confident that a quasi-fixed exchange rate regime would facilitate EMU entry two years after accession. Opponents of early EMU entry argue that such a regime would have a high probability of breaking down, and even if it were sustained it would be at the cost of subjecting all other goals of macroeconomic policy making to this target, which could entail significant welfare costs. Furthermore the regime might be sustained just in order to achieve EMU entry, after which structural problems would re-emerge (consider the experience of EMU members such as Portugal and Italy). The last point to be mentioned in this context is the inconsistency between the goal of early EMU entry and the transitory restrictions imposed on labour flows between the EU-15 and the accession countries. These restrictions – which permit the EU-15 countries unilaterally to impose restrictions on labour flows for a period of up to seven years after accession – are of course contrary to a crucial OCA criterion: a high degree of labour mobility across regions to accommodate asymmetric shocks. While this does not necessarily require international mobility of labour and could be partly dealt with by high intracountry and interregional labour flows, in the short term there will clearly be problems with increasing the rather low intraregional mobility rates in the accession countries as these are caused by deep-seated structural barriers (particularly in the housing market, through high transport costs and infrastructural bottlenecks) that cannot be removed quickly.

Growth implications of EU membership for CEECs In this section we shall discuss the possible growth trajectories of the new member countries, review some of the research in this area and discuss

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various factors that are directly related to EU accession and might affect the growth trajectories. Over the past two decades there has been a dramatic increase in the body of theoretical literature on growth and numerous empirical and econometric studies have been conducted. Growth analysis has dealt with most of the topics that are relevant to assessing the long-term performance of accession countries, including openness and growth, regional integration and convergence, institutional and political–economic determinants of growth, growth and income distribution, development traps and regional economic growth, growth and factor mobility, technology transfers, infrastructure, human capital and FDI. In addition to cross-country regression analyses there are a large number of in-depth country studies (for example Rodrik, 2003; GDN, 2002), which are increasingly being seen as important complements to cross-country analysis. It has been found that regional integration does support convergence, although there might be phases in which the impact is weak; regional integration particularly benefits countries whose income level is below a certain threshold (for estimates that are directly applicable to accession see Crespo et al., 2002); and investment rates and stocks of human capital are very important for growth and catching up. There is also evidence on the impact of international technology transfers, on the fact that institutions matter, that regional convergence processes within countries can come to a halt, and that there may be development traps. There has been some analysis of the impact of EU transfers on economic growth and catching up, based largely on the experience of the cohesion countries and usually relying on model simulations (for example Moucque, 2000; European Commission, 2001b). Before assessing the growth implications of EU accession we shall quickly review the recent growth experiences of the accession countries.9 Figure 6.5 shows the growth trajectories of the accession countries and the EU-15 during 1994–2002 for GDP, employment and GDP per employee (we shall call the latter variable ‘macro-productivity’). During this period, which followed the transformational recession, there was a clear growth differential between the accession countries and the EU-15, amounting to 1.3 per cent per annum for GDP growth and 2.6 per cent for macro-productivity (the difference was due to poor employment growth in the accession countries). These rates fall within the band of measures that have been estimated in the recent literature on convergence. However they fall significantly short of the rates enjoyed by some of the South-East Asian economies from the 1970s onwards – we shall discuss below whether there is any likelihood of the accession countries replicating this performance. The graphs for manufacturing show that the differences in the growth trajectories in output and (labour) productivity in this sector between the EU-15 and the accession countries was more pronounced than for GDP as a whole: in 1994–2001 the

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growth differential for output amounted to 4.6 per cent per annum and for productivity 7.0 per cent. This confirms the productivity growth (catchingup) differential between the tradable and non-tradable sectors underlying the Balassa–Samuelson hypothesis, as manufacturing accounted for a large share of the tradable sector. The aggregate trends in Figure 6.5 hide differences between the growth performances of the individual countries. Figure 6.6 shows that at the individual country level there was considerable volatility (as there was, of course, in the EU-15). This was due to external account and exchange rate crises (the Czech Republic in 1997–98, Slovakia in 1999–2000 and Poland in 2001–2), which were often combined with banking and corporate restructuring problems. There were also the effects of external shocks, such as the Russian crisis in the case of the Baltic states.

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It is likely that some of the factors that have contributed to the volatility in the accession countries will persist: the need for long-term capital inflows combined with the natural tendency of catching-up economies to operate under structural current account deficits will provide the basis for swings in external economic relations, as economic policy has to be aimed at both nominal stability and the medium-term requirements of the catching-up

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process. Furthermore there is evidence that the transition/catching-up economies will undergo pronounced political swings that will translate into more accentuated political–business cycles. The underlying causes of this will be the less than consolidated structure of political representation by political actors/parties, plus painful structural reforms which are still in process, such as social security reforms and the impact of the structural transformation process on labour markets, regions, demographic and professional groups and so on. Moreover the strained fiscal situation will make stop–go policies more likely, and the underdeveloped system of financial intermediation provides a weaker domestic base for capital market transactions and therefore lessens the scope for intertemporal smoothing. Hence for quite some time the accession countries’ growth trajectories are likely to be more volatile than those of the advanced EU market economies (for some general evidence that growth is more volatile in lower-income countries, see Azariadis, forthcoming). On the other hand there has been a rather dramatic upgrading of industrial structures in the accession countries (for details see Landesmann, 2000). Contrary to the prediction of classical trade theory, there has been a strong ‘Gerschenkron’ pattern of differential catching up (see Landesmann and Stehrer, 2001, 2002), that is, some of the accession countries have been able to exploit their ‘advantage of backwardness’ most strongly in sectors that are technologically demanding and require skilled labour inputs. This has turned their comparative advantage away from labour- and low-skillintensive industrial sectors and considerably strengthened their presence in medium to high-tech sectors (Figure 6.7), which exceeds that of some of the Southern European cohesion countries (WIIW, 2003). Thus from a structural point of view there have been very promising developments in the accession countries, although the extent of this varies from country to country. The same is true of market services, which complement the upgrading of industrial and other sectors by providing essential inputs for organizational change. Just as in manufacturing, the involvement of foreign-owned companies has been crucial to the development of the market services sector, which brings us to the potential boost that accession might give to foreign direct investment (FDI) flows and the growth prospect of the accession countries. On the level of aggregate effective demand, the impact of FDI on growth is discussed by Laski and Römisch in Chapter 8 of this volume. The other feature that is prominently analyzed in the literature is the supply-side impact of increased FDI flows and the spread of cross-border production networks. We know from global evidence (as, for example, in the UNCTAD World Investment Reports) and the experiences in Central and Eastern Europe (for example Hunya, 2002) that FDI is an important transmitter of technological, organizational and market know-how, that it facilitates access to the markets in which international firms operate, and that it bundles together complementary assets (managerial, organizational, labour, capital and so on)

Michael A. Landesmann and Sándor Richter 179 (a)

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that reflect firms’ assets and the relative factor endowments of host and source countries. Thus FDI activities are generally recognized as allowing the exploitation of international location advantages, intrafirm divisions of labour and economies of scope and scale. All these factors have been and will continue to be of great importance to the accession countries as their

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legal, institutional and behavioural convergence processes gain speed. The institutional and legal integration of these countries into the EU is expected to provide an additional impetus to cross-border corporate activities between the new and (especially neighbouring) old members. Given the asymmetry of the relative economic weights, the impact will be felt much more strongly in the new member countries (see Breuss’s estimates in Chapter 7 of this volume). However FDI stocks have already reached very high levels in some of the accession countries, so the increased corporate cross-border linkages might not show up in dramatically increased FDI flows but in the deepening of cross-border corporate structures, technological and organizational know-how transfers and cross-border labour movements. When considering growth in the accession countries it should be remembered that this varies considerably across regions. In particular there is a large difference between growth in the regions bordering the EU and that in more distant regions; furthermore, capital cities attract a large proportion of FDI and tertiary activities, which translates into a much better labour market and income performance (for a detailed analysis see Römisch, 2003). After accession the regional disparities could become even more pronounced because there is likely to be a strengthening of production networks in regions where transportation costs are low, where there is a high density of communication channels and where the integration of transportation and other infrastructural facilities across borders can be carried out most easily. This could be further strengthened by transborder bilateral policies and EU support for border regions. Over time, however, interregional spillovers and tight labour-market and land situations in border regions and capital cities might lead to some diffusion of the agglomeration tendency and the gradual development of more peripheral regions. However West European experience shows that some regions can be locked into a peripheral status (consider Italy’s Mezzogiorno) that is very difficult to overcome even if substantial resources are devoted to the task. There has recently been a lively and heated discussion on the impact that the EU Structural and Cohesion Funds could have on the accession countries (see for example Boldrin and Canova, 2001, 2003; Hallett, 2002). Convincing proof of whether regional policy has growth-enhancing or merely redistributive effects is not available, and hence its effectiveness remains disputed. Boldrin and Canova (2001) outline a theoretical model on which any argument for the growth-enhancing effects of regional policy must be based. Such a model must make a convincing case for threshold phenomena and other increasing returns to scale phenomena that provide the basis for analysing why market forces could lead to divergent growth processes and poverty traps (see the survey by Azariadis, forthcoming). Hallett (2002), on the other hand, emphasizes the conditionality of the effectiveness of regional policies on institutional developments and the effective use of other policy instruments, as well as on structural features of

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labour and product markets, and so on. Judging by the experiences of the cohesion countries, the effect of EU structural policies on growth at the regional and national levels in the new member states will vary considerably. A simple growth model that assumes uniform convergence or divergence across regions or countries is therefore bound to be misleading. Finally, we shall now address the question of whether the accession countries can expect the ‘growth miracle’ experienced in South-East Asia (and Ireland for that matter). The catching-up processes in the accession countries are taking place in an historical context that is quite distinct from that which prevailed in South-East Asia, especially in respect of the degree to which international economic relations have been liberalized (product markets, capital markets and, to a lesser extent, labour markets). Consequently the range of policies that the accession countries can use to intervene in the growth process are very different from those which were available to the South-East Asian countries (this refers both to macro and to micro policies). Even in comparison with previous EU entrants, the current degree of EU integration is far greater than it was at the time of previous enlargements and consequently the range of policy options and the degree of institutional diversity are now far more constrained. The other side of the coin is that the accession countries will benefit from faster and less costly channels of technology transfer, lower entry barriers, lower copying costs for institutional and legal designs and EU-funded programmes to overcome developmental gaps. All in all, at this stage one should probably shy away from predicting whether a much speedier catching-up process might be feasible in the accession countries than is currently observed, and instead define the policy options that are presently available, analyse the uses that can be made of these options and focus on the design of policy packages (at the regional, national and EU levels) to sustain growth. Notes 1. Seventy per cent was the (rounded) average success rate of the EU-15 and 50 per cent was the (rounded) average of the worst EU-15 performers in their worst years in 1994–99. For an explanation of the choice of these two rates see Richter (2002). For detailed statistics on the success rates of the EU-15 see European Commission (2001b), Statistical Annex, Table A.35. 2. For some countries the success rate may have been even be worse than 50 per cent, as indicated by the discouraging examples of preaccession aid. 3. Estimate by Gábor Hunya at WIIW. 4. See Kopits and Székely (2002), Breuss (2001), Havlik (2002), Fidrmuc et al. (2002). 5. The fourth solution would result in separate standards for the old and new members, which would contradict the basic principle of the EU. 6. As cited by Karlsson (2002), p. 63. 7. Belgium had one region, Germany six, France five, Italy eight, the Netherlands one, Austria one, the UK three. Sweden and Finland had special support for their

182 Consequences of Accession northern territories. The only countries left out were Luxemburg and Denmark (see European Commission, 2002c, p. A-19). 8. There is evidence of somewhat higher degrees of industrial concentration and specialization compared with the advanced EU members (see WIIW, 2003). 9. In Chapter 8 of this volume Laski and Römisch discuss the various statistical measures that can be employed to study growth differentials – these measures do not always produce the same results.

References Azariadis, C. (forthcoming) ‘Poverty Traps’, in P. Aghion and S. N. Durlauf, Handbook of Economic Growth (Amsterdam: Elsevier). Backé, Peter (2002) ‘Fiscal Effects of EU Membership for Central European and Baltic EU Accession Countries’, Focus in Transition, no. 2, pp. 151–65. Begg, D., B. Eichengreen, L. Halpern, J. von Hagen and Ch. Wyplosz (2002) ‘Sustainable Regimes of Capital Movements in Accession Countries’, Centre for Economic Policy Research Paper no. 10 (London: CEPR). Boldrin, M. and F. Canova (2001) ‘Inequality and convergence: reconsidering European regional policies’, Economic Policy, vol. 32, pp. 205–53. Boldrin, M. and F. Canova (2003) ‘Regional Policies and EU Enlargement’, CEPR Discussion Paper no. 3744 (London: CEPR). Breuss, Fritz (2001) ‘Macroeconomic Effects of EU Enlargement for Old and New Members’, WIFO Working Papers no. 33 (Vienna: WIFO, June). Buiter, W. H. and C. Grafe (2003) ‘Patching up the pact: some suggestions for enhancing fiscal sustainability and macroeconomic stability in an enlarged European Union’, unpublished manuscript (London: European Bank for Reconstruction and Development). Coricelli, F. and B. Jazbec (2001) ‘Real exchange rate dynamics in transition economies’, CEPR Discussion Paper no. 2869 (London: CEPR). Crespo-Cuaresma, J., M. A. Dimitz and D. Ritzberger-Grünwald (2002) ‘Growth effects of European integration: implications for EU Enlargement’, Focus of Transition, no. 1 (Vienna: Austrian National Bank). European Commission (1998) Financing the European Union. Commission Report on the Operation of the Own Resources System (Brussels: European Commission, 7 October). European Commission (2001a) Second Report on Economic and Social Cohesion, COM (2001) 24 final. European Commission (2001b) Allocation of 2000 EU operating expenditure by member states (Brussels: European Commission). European Commission (2002a) Communication from the Commission. Information Note. Common Financial Framework 2004–2006 for the Accession Negotiations, SEC (2002) 102 final (Brussels: European Commission, 30 January). European Commission (2002b) Enlargement and Agriculture: Successfully integrating the new Member States into the CAP, Issues paper SEC (2002) 95 final (Brussels: European Commission, 30 January). European Commission (2002c) First progress report on economic and social cohesion, COM 2002, 46 final (Brussels: European Commission, 30 January). European Commission (2002d) Towards the Enlarged Union. Strategy paper and report of the European Commission on the progress towards accession by each of the candidate countries (Brussels: European Commission, 9 October). Also available at http://europa.eu.int/comm/enlargement/ report2002/strategy_en.pdf.

Michael A. Landesmann and Sándor Richter 183 European Commission (2002e) The EU Economy. 2002 Review (Brussels: Directorate General for Economic and Financial Affairs). Fidrmuc, Jarko, Gabriel Moser, Wolfgang Pointner, Doris Ritzberger-Grünwald, Paul Schmidt, Martin Schneider, Alexandra Schober-Rhomberg and Beat Weber (2002) ‘EU Enlargement to the East: Effects on the EU-15 in General and on Austria in Particular. An Overview of the Literature on Selected Aspects’, Focus on Transition, no. 1, pp. 44–70. Frankel, J. and A. Rose (2002) ‘An estimate of the effect of common currencies on trade and income’, Quarterly Journal of Economics, vol. 117, no. 2, pp. 437–66. Global Development Network (GDN) (2002) Explaining Growth – Country Studies (Washington, DC: GDN). Hallett, M. (2002) ‘Income convergence and regional policies in Europe: results and future challenges’ (in Spanish), Papeles de Economia Espanola, no. 93, pp. 38–50. Halpern, L. and C. Wyplosz (1997) ‘Equilibrium exchange rates in transition economies’, IMF Staff Papers 44/4 (Washington, DC: IMF), pp. 430–61. Halpern, L. and C. Wyplosz (2001) ‘Economic Transformation and Real Exchange Rates in the 2000s: The Balassa–Samuelson Connection’, Economic Survey of Europe, no. 1 (Geneva: United Nations), pp. 227–39. Havlik, Peter (2002) ‘EU Enlargement: Economic Impacts on Austria and the Five Acceding Central European Countries’, WIIW Research Reports no. 290 (Vienna: Vienna Institute for International Economic Studies, October). Hunya, G. (2002) ‘Recent Impacts of Foreign Direct Investment on Growth and Restructuring in Central European Transition Countries’, WIIW Research Reports no. 284 (Vienna: Vienna Institute for International Economic Studies). Karlsson, Bengt O. (2002) What Price Enlargement? Implications of an expanded EU (Stockholm: The Expert Group on Public Finance). Kopits, George and István Székely (2002) ‘Fiscal Policy Challenges of EU Accession for Central European Accession Countries’, paper presented at the OeNB East West Conference, Vienna, 3–5 November 2002. Krugman, P. (1993) ‘Lessons of Massachusetts for EMU’, in F. Torres and F. Giavazzi (eds), Adjustment and Growth in the European Monetary Union (Cambridge: Cambridge University Press). Landesmann, M. A. (2000) ‘Structural Change in the Transition Economies, 1989–1999’, Economic Survey of Europe, nos 2–3 (Geneva: United Nations), pp. 95–117. Landesmann, M. A. and R. Stehrer (2001) ‘Potential Switchovers in Comparative Advantage: Patterns of Industrial Convergence’, Structural Change and Economic Dynamics, vol. 12, no. 4, pp. 399–423. Landesmann, M. A. and R. Stehrer (2002) ‘Evolving Competitiveness of CEECs in an Enlarged Europe’, Rivista di Politica Economia, vol. 92, no. 1, pp. 23–87. Lawrence, R. (1996) Regionalism, multilateralism and deeper integration (Washington, DC: Brookings Institution). Lödl, Manfred Claus (2002) ‘Das EU-Budget und die öffentlichen Haushalte in Österreich’, in Gerhard Steger (ed.), Öffentliche Haushalte in Österreich (Vienna: Verlag Österreich). Lolos, Sarantis E. G. (2001) ‘The Macroeconomic Effect of EU Structural Transfers on the Cohesion Countries and Lessons for the CEECs’, Interim Report IR-01044/October (Vienna: IIASA). Moucque, D. (2000) ‘A survey of socio-economic disparities between the regions of the EU’, in European Investment Bank, Regional convergence in Europe: theory and empirical evidence, EIB Papers 5/2 (London: EIB), pp. 13–24.

184 Consequences of Accession Richter, Sándor (2002) ‘The EU Enlargement Process: Current State of Play and Stumbling Blocks’, WIIW Current Analyses and Country Profiles, no. 17 (April). Richter, Sándor (2003) ‘Die EU-Erweiterung nach Kopenhagen’, Europäische Rundschau, vol. 31, no. 1, pp. 93–105. Rodrik, D. (ed.) (2003) In Search of Prosperity: Analytical Narratives on Economic Growth (Princeton, NJ: Princeton University Press). Römisch, R. (2003) ‘Developments in regional GDP and regional unemployment’, in Michael A. Landesmann (ed.), WIIW Structural Report 2003 (Vienna: Vienna Institute for International Economic Studies). Tarschys, D. (2000) ‘Bra träffbild, fast utanför tavlan’, ESO Ds 2000:60 (October). United Nations Conference on Trade and Development (various years), World Investment Report (Geneva: UNCTAD). WIIW (2003) ‘Enlargement and Competitiveness’, ch. 4 in Background Report to the European Competitiveness Report (Vienna: Vienna Institute for International Economic Studies). Wyplosz, C. (2002) ‘Fiscal discipline in EMU: rules or institutions’, paper prepared for a meeting of the Group of Economic Analysis of the European Commission, 16 April.

7 The Political Millennium Event: EU Enlargement as an Economic Challenge Fritz Breuss

Introduction1 After the successful launch of the euro, EU enlargement is the next big challenge for the European Union. It will not only be a historic event that ends the postwar political separation of Europe, but will also have far-reaching economic implications. The eastward enlargement of the EU will be the fifth enlargement since the European Community was established in 1957. The first, conducted in 1973, was labelled the ‘northern enlargement’ (Denmark, Ireland and the United Kingdom). The second (Greece in 1981) and third (Portugal and Spain in 1986) were called ‘southern enlargements’. The fourth enlargement (Austria, Finland and Sweden in 1995) required no special label as the new members switched from EFTA to the EU. Due to the increasing attraction of the EU, the formerly competing integration bodies in Europe turned into a nearly monolithic EU bloc of 15 member states and a remaining mini-EFTA with four members (Iceland, Liechtenstein, Norway and Switzerland), and even the latter are strongly integrated into the EU Single Market via the European Economic Area (EEA) agreements of 1994 (with the exception of Switzerland). The eastward enlargement is a huge challenge but also promises considerable economic opportunities for the EU and the applicant countries. First, on 1 May 2004 the EU will be enlarged by 10 new member states (Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuqnia, Malta, Poland, Slovakia and Slovenia). This will increase the area of the EU by 23 per cent, its population by 20 per cent and absolute GDP by 9 per cent. A further EU enlargement could comprise Bulgaria and Romania as well as the countries of the Balkan region (Albania, Bosnia-Herzegovina, Croatia, Macedonia, Serbia and Montenegro) and Turkey. Second, the Central and East European countries (CEECs) that are set to join the EU are relatively poor, with a per capita GDP of only about 47 per cent of the EU average, and they are below the ceiling for objective 1 status (less than 75 per cent of the average EU per capita GDP). Hence the average 185

186 EU Enlargement as an Economic Challenge

per capita GDP in the enlarged EU will be about 9 per cent less than at present. According to the acquis communautaire, poor members cost more in terms of structural transfers than rich candidates (such as those in the fourth enlargement). As with the third enlargement, the next one will pose a challenge for convergence as the integration of poor with rich countries will increase the heterogeneity of the EU. In order to be prepared for eastward enlargement, the European Commission (1997, p. 21 ff.) proposed reforms of the Common Agricultural Policy (CAP) and the structural policy to obtain the financial means to finance enlargement. These reforms (which would result in a cut in appropriations for the EU incumbents) were agreed upon by the heads of state and government at a special meeting of the European Council in Berlin in March 1999. Together with the institutional reforms brought about by the Nice Treaty (December 2000), the reforms enabled the EU to enlarge by up to 12 new members. Third, whereas the last EU entrants were market economies, the new applicant countries (except Cyprus and Malta) switched from planned to market economies only in 1989 and are still in the process of transition. The readiness of the candidate countries for EU membership is evaluated by the European Commission (which publishes a progress report at the end of each year) according to the three sets of criteria formulated by the European Council in Copenhagen in June 1993 (European Commission, 1997, p. 43): political criteria (the applicant must have ‘achieved stability of institutions guaranteeing democracy, the rule of law, human rights, and respect for and protection of minorities’); economic criteria (‘the existence of a functioning market economy as well as the capacity to cope with competitive pressure and market forces within the Union’); and acquis criteria (‘the ability to take on the obligations of membership, including adherence to the aims of political, economic and monetary union’). The 8 CEECs, Cyprus and Malta will enter the EU on the basis of the Nice Treaty. This implies not only adherence to the targets for EMU but also adoption of the Schengen acquis. According to the ‘road map’ for negotiations that was agreed upon by the European Council in Nice in December 2000, negotiations had to be finalized by the end of 2002. The results of the European Council in Copenhagen in December 2002 are documented in a Treaty of Accession (with appendices containing transitional regulations for each candidate country). This treaty was signed under the Greek presidency in Athens, 16 April 2003. The subsequent ratification process in the 15 EU member states and the candidate countries is paving the way for accession of 10 new members on 1 May 2004. In between the defining of the accession criteria in 1993 in Copenhagen and the signing of the Accession Treaty in 2002 in Copenhagen (“from Copenhagen to Copenhagen”) a series of measures were taken: trade integration via the Europe Agreements, which brought about free trade via

Fritz Breuss 187

asymmetric trade liberalization (the EU abolished tariffs on imports from the CEECs in 1997, the CEECs abolished their tariffs on imports from the EU in 2002); the inclusion in the Europe Agreements of an accession option for the CEECs; the drafting of ‘Agenda 2000’ in June 1997 by the European Commission, providing the financial perspective for an enlarged union; evaluation of the CEEC applicants based on the Copenhagen criteria; and the start of negotiations in early 1998 with the six countries of the ‘Luxembourg group’ (the Czech Republic, Estonia, Hungary, Poland, Slovenia and Cyprus), followed in early 2000 by the six countries in the ‘Helsinki group’ (Bulgaria, Latvia, Lithuania, Slovakia, Romania and Malta). Running parallel to the accession negotiations has been a so-called preaccession strategy to prepare the candidate countries for entry (via the Phare, ISPA and SAPARD programmes, for which €3.1 billion per year are reserved in the EU budget; see EU, 2001e, for a detailed history of the enlargement process). The candidate countries were permanently evaluated according to the acquis communautaire, broken down into 31 chapters (ranging from the four freedoms to financial and budgetary provisions). Turkey was designated as an official candidate at the European Council in Helsinki in December 1999. The EU has adopted a different strategy for the Balkan region, based on Stabilization and Association Agreements (SAA). According to the European Council in Copenhagen in December 2002, Bulgaria and Romania will enter the EU in 2007. This might also be the case for Croatia which applied for EU membership in early 2003. In the case of Turkey the Commission has to prepare a report by the end of 2004. If positive, accession negotiations could start in 2005. The development of European integration started in the 1960s with a simple customs union (the EEC) and free trade area (EFTA). Step by step, various areas of economic policy were harmonized or centralized (the Common Agricultural Policy, Common Commercial Policy and so on) and in 1993 the Single Market was created (with the realization of the four freedoms and the introduction of a strong competition policy). European Monetary Union (EMU), with a single currency (the euro) and a centralized monetary policy and coordinated fiscal policy, began in 1999. Real development and theory were mutually stimulated by the increasing complexity of the integration process (see Breuss, 1996). The creation of regional free trade areas (the Benelux customs union in 1944, the EEC customs union in 1957, and EFTA in 1960) stimulated the theory of customs union (Viner, 1950), which was further developed with the advancement of economic integration in Europe (Corden, 1972). The completion of the Single Market in 1993 challenged theoreticians to model complex effects after the realization of the four freedoms and the strengthening of the centralized competition policy. As a result, partial and general equilibrium

188 EU Enlargement as an Economic Challenge

models with imperfect (monopolistic) competition à la Dixit and Stiglitz (1977), product variety and economies of scale were constructed to capture the effects of a single market with intensified competition. EMU is an even more difficult subject for researchers as it is unprecedented for independent states to give up their own currency in favour of a common currency and centralized monetary policy. The tasks of the European Convention, initiated by the declaration on the future of the European Union at the European Council meeting in Laeken in December 2001, were to simplify the treaties in order to improve democracy, transparency and efficiency (a better division and definition of competences including primary law, a charter of fundamental rights and a constitution). On 18 July 2003 the Convention presented a draft treaty establishing a Constitution for Europe which had to be finalized by the Intergovernmental Conference in 2004. Given their unfavourable performance in terms of inflation and interest rates and the uncertain development of their exchange rates, when the CEECs enter the EU they will not be able immediately to join EMU. This, and because of possible temporary restrictions in other policy areas (such as on the free movement of people to prevent mass immigration), will increase the character of the EU as an à la carte organization, with all the related management difficulties. A certain asymmetry characterizes the accession negotiations. It is the rich countries of the EU that decide whether and when to invite poorer countries to join the club, and under what conditions (the Copenhagen criteria, the acquis communautaire). In the negotiation game there is a trade-off between the higher costs of early integration, combined with higher possible integration gains and the lower costs of postponing accession until the applicants’ per capita GDP has drawn closer to the EU level, which can however reduce the integration effects (see Martin, 1996; Breuss, 2002). EU enlargement is a project with global political dimensions (peace in Europe, the unification of East and West, the transformation of the EU into a world power) and far-reaching economic implications. While there have been some studies of the potential welfare effects of enlargement for the EU and CEECs as a whole (for example Brown et al., 1997; Baldwin et al., 1997; Neck et al., 1999; Lejour et al., 2001; Breuss, 2000b; EU, 2001d) and of possible effects on some individual countries (Breuss and Schebeck, 1999; Breuss, 1999; Keuschnigg and Kohler, 1999; Keuschnigg et al., 1999; Madsen and Sorensen, 2002), they have not included all the effects one could expect of the integration of a rich region with a poor one. Moreover they have not analysed the consequences for all of the countries involved in the enlargement process. This chapter proposes to remedy these shortcomings by not only considering the possible effects of this type of regional integration but also analysing the consequences for the current EU member states and the new members. This will be done with the help of a world macro model: the

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Oxford Economic Forecasting (OEF) world macroeconomic model, which will enable us to analyse the effects on 13 EU countries (plus other large OECD countries), three CEECs and Eastern Europe as a bloc. It will be assumed that enlargement will take place in 2005. The three CEECs that will be dealt with explicitly – the Czech Republic, Hungary and Poland – account for two-thirds of the CEEC-10’s total GDP and their per capita GDP is higher than those of the other CEECs by around 15 per cent. Hence the largest of the CEEC-10 economies will be covered by our analysis. The study will look at the benefits of EU enlargement in terms of real GDP growth for old and new EU members, and at the possible dangers of merging a rich bloc of more or less harmonized economies, with a bloc of poor economies that are still in transition. According to the official doctrine, EU enlargement will take place in two steps: (1) the entry of new members to the Single Market and (2) the entry of these members to EMU. This ‘flexible integration’ could serve to weaken the EU. Whereas at present 12 out of the 15 EU member states are in the euro zone, after enlargement the majority will be outside (13 out of 25). We shall first analyse the possible effects of step 1, and then, based on the outcome of this exercise, we shall analyse the implications for macroeconomic stability in the euro zone. If enlargement leads to different impacts on GDP growth and inflation among the incumbents of the euro zone, macroeconomic stability could be endangered. Moreover enlargement is not only about trade and growth potential, but also about income redistribution between labour market winners and losers. Because of the likely differential macroeconomic impact on the EU member countries (real GDP, prices, real exchange rates, current account), enlargement could also be viewed as an external shock that will hit the EU-15 asymmetrically and hence introduce new disturbances into the EU.

The OEF world macroeconomic model The OEF world macroeconomic model (OEF, 2000) is a traditional Mundell–Fleming macro model with standard demand and supply equations, most of which consist of estimated parameters. Whereas the functional form for equations is left the same across countries, the estimated parameters differ. A typical Oxford country model consists of equations for four blocks: (1) the demand side, consisting of the goods market (consumption, investment, imports and exports) and the money market (money balances, long bond rates, exchange rates); (2) the supply side, consisting of capital accumulation (capital stock, non-residential investment, real interest rates), the labour market (labour supply, participation rate, natural rate of unemployment, natural employment level, potential output, output gap, employment, average earnings) and prices (GDP deflator, import prices, consumer prices); (3) government policy, consisting of monetary policy and

190 EU Enlargement as an Economic Challenge

fiscal policy; and (4) the rest of the world (world trade and world prices). The Oxford model also includes a special section for the financial market and special features for emerging market economies (risk premia). In the long run, each economy behaves like the textbook description of a one-sector economy with Cobb–Douglas technology in equilibrium. The ‘core’ of the model comprises 24 country models together with six trading blocs and 14 ‘emerging market’ country models. The country models are fully interlinked via trade, prices, exchange rates and interest rates, with the blocs covering the entire world. For our purposes the EU consists of 13 explicit country models and the CEEC of country models for the Czech Republic, Hungary and Poland and the East European bloc (Bulgaria, the Czech Republic, Hungary, Kazakhstan, Poland, Romania, Russia, Slovenia and Ukraine). As a baseline for our calculations, the latest OEF 10-year forecast is used, assuming no enlargement, an adaptive economic policy stance, price stability in the euro zone, fiscal discipline according to the Stability and Growth Pact targets (zero budget balance in the medium term) and the same interest rates throughout the euro zone. Although EU enlargement starts officially on 1 May 2004 we assume that the economic integration effects will become effective only in 2005.

Integration effects of EU enlargement Integration effects always depend on the degree of integration. In case of the EU, integration has gone through three stages: customs union, the Single Market and Economic and Monetary Union. It is realistic to assume a twostep procedure for the new members: (1) entry to the Single Market, and (2) participation in EMU (EU, 2001b). Entering EMU from the very beginning will be neither possible (because most of the candidate countries have not yet fulfilled the convergence criteria) nor desirable. The following estimates therefore refer to the implications of joining the Single Market. We shall consider the standard effects of regional integration (see Baldwin and Venables, 1995) plus some specific aspects of EU enlargement: ● ●

●

●

Trade effects: cost savings via the abolition of import tariffs and trade costs. Single Market effects: improvement in efficiency and greater price competition. Factor movements: foreign direct investment flows from the West to the East, labour migration in the other direction. Costs of enlargement for the old EU members and transfers to the new members.

EU enlargement is a project of regional integration with two obvious asymmetries. On the one hand a bloc of rich countries is integrating a bloc of poor countries, and on the other hand a large bloc is integrating a small one. At present all the candidate countries are poor in comparison with the

Fritz Breuss 191

EU-15. On average the per capita GDP of the former in PPP terms is about 40 per cent of that of the latter (Table 7.1). Of the CEECs, the Czech Republic, Hungary and Poland (CEEC-3) are about 15 per cent richer than the CEEC-10. In PPP terms the GDP of the CEEC-10 is around 10 per cent of that of the EU, and measured at current prices it amounts to about 5 per cent of the EU’s GDP. The GDP of the CEEC-3 bloc amounts to two thirds of that of CEEC-10. The labour productivity of the CEEC-10 is 40 per cent of the EU average, the share of agriculture in their economies is four times higher than in the EU, on average and monthly wages are only 35 per cent of those in the EU. Trade with the EU is much more important for the CEECs than is trade with the CEECs for the EU, at a ratio of nearly 1 : 20. The countries with the greatest Table 7.1 The dimensions of EU enlargement: EU and CEEC, 1999

Structural indicators: Population (million) Dependent employment (1000 persons) Employment total (1000 persons) GDP (PPP, billion euros) (billion euros) GDP per capita (PPP, (euros) GDP/employment (PPP, euros) Labour productivity (euro) Monthly gross wages (PPP, euros) (euros) Agricultural sector (% of GDP) % of employment FDI inflows (million US dollars)* (% of GDP) Foreign trade: Exports to CEEC (million US dollars) (% of total exports) (% of GDP) Imports from CEEC (million US dollars) (% of total imports) (% of GDP) Exports to EU (million US dollars) (% of total exports) % of GDP

CEEC-10 CEEC-3 EU-15 CEEC-10 ⫽ 100 ⫽100

EU-15

CEEC-10

CEEC-3

376

105

59

27.83

56.41

133 132

27 842

15 665

20.91

56.27

157 244 7 962 7 964 21 182 21 188 50 637 50 650 1 987 2 007 1.70 5.10 215 864 2.54

42 239 831 341 7 946 3 262 19 676 8 078 714 301 7.20 16.10 16 599 4.56

24 216 539 240 9 139 4 063 22 266 9 898 837 375 4.30 10.10 12 968 5.07

26.86 10.44 4.28 37.51 15.40 38.86 15.95 35.91 14.98 423.53 315.69 7.69 179.49

57.33 64.88 70.25 115.02 124.55 113.16 122.54 117.37 124.58 59.72 62.73 78.13 111.18

80 645 68.50 22.15

56 955 71.90 22.27

99 088 4.58 1.17 82 794 3.94 0.97 70.62 104.96 100.52

192 EU Enlargement as an Economic Challenge Table 7.1 Continued

EU-15

CEEC-10

CEEC-3

94 036 62.14 25.83

66 332 64.56 25.94

70.54 103.89 100.41

200 000 210 000

⫺200 000 ⫺210 000

⫺143 700 ⫺72 100

71.85 34.33

⫺190 ⫺0.15 ⫺39 ⫺0.30

190 2.10 39 3.68

134 2.48 27 4.35

70.70 118.10 69.77 118.21

Imports from EU (million US dollars) (% of total imports) (% of GDP) Migration: 5 CEEC in 2005 (no. of persons) 5 ⫹ 5 CEEC in 2007 (no. of persons) Costs of enlargement: Transfers from EU budget, net: Cumulative 2000–10 (billion euros) (% of GDP) In 2010 (billion euros) % of GDP

CEEC-10 CEEC-3 EU-15 CEEC-10 ⫽ 100 ⫽100

* EU-15, 1998. CEEC-10 = Bulgaria, Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Romania, Slovakia, Slovenia. CEEC-3 = Czech Republic, Hungary, Poland. Sources: Eurostat; OECD; WIFO; WIIW.

volume of trade with CEECs are Austria (an export share of 13.3 per cent versus an import share of 9.4 per cent), Germany (8 per cent versus 8.5 per cent), Greece (8.8 per cent versus 3.5 per cent), Finland (7.6 per cent versus 4.1 per cent), Italy (5.4 per cent versus 4.2 per cent) and Sweden (4.3 per cent versus 4.1 per cent). Integration will affect not only trade flows but also factor movements. Although at first glance EU enlargement is similar to the NAFTA integration, participation in the Single Market programme and then in EMU constitutes a much higher degree of integration than is the case with the North American venture. Due to the fact that the new member countries are quite small compared with the EU-15, the impact of their development on the EU-15 is likely to be small. Trade effects The EU has concluded Europe Agreements with ten CEECs, which implies that an asymmetric tariff reduction has taken place in trade between them and the EU. From 1997 the EU eliminated practically all tariffs (except on agricultural and other sensitive products) on imports from the CEECs, and the CEECs did likewise in 2002. When they join the EU the CEECs will enter the customs union (the Common External Tariff and Common Commercial Policy) and border controls will be abolished, thus reducing trade costs. Estimates of the cost savings from eliminating border controls range from

Fritz Breuss 193

5 per cent (Kohler, 2000) to 10 per cent (Baldwin et al., 1997). Here we shall assume that the remaining CEEC import tariffs in 2002 amounted to 5 per cent. The reduction of trade costs at the time of accession are also assumed to be 5 per cent. While the complete elimination of tariffs will lead to welfare losses in the CEECs (domestically captured rents), the reduction in trade costs will improve trade flows (trade creation). Model inputs In order to measure the trade effects of enlargement, one should ideally employ bilateral trade equations connecting the 15 EU member states with the 10 CEECs. As a rule no world model – neither Computable General Equilibrium (CGE) nor macro – consists of such a detailed trade network. As a compromise, here the bilateral trade effects are calculated outside the model by using simple (trade weighted) import equations with the assumption of an average price elasticity. The trade effects of the elimination of tariffs in the CEEC-3 and the trade costs for both the EU and the CEEC-3 are estimated and the values imputed into the OEF model equations for exports only because export-led increases in real GDP generate additional imports. Finally, use of a trade-linked world model can reveal spillover effects that are not usually captured by CGE models. Model results Because nearly 70 per cent of CEEC exports are sent to the EU but only 4 per cent of total EU trade is conducted with the CEECs the trade effects are considerably larger for the CEECs than for the EU (see Table 7.1 above). The partial trade effect will lead to a cumulative increase of real GDP in the EU of roughly 0.05 per cent over the period 2005–10. Austria and the Netherlands will gain the most – about 0.25 per cent – and France, Ireland and Italy will gain about 0.1–0.2 per cent, but Spain and the United Kingdom will lose. The trade-induced GDP effect in the CEECs will be nearly ten times larger. In Hungary real GDP will be stimulated by approximately 4.5 per cent (cumulatively over the period 2001–10), while the figure for Poland and the Czech Republic will be about half of that. The elimination of the remaining import tariffs will result in lost budget revenues of about 1–1.5 per cent of GDP. The reduction of trade costs (Single Market entrance) will lead to trade creation in the EU and the CEECs without directly worsening the budget. The trade effects do not imply major disturbances in other macroeconomic variables: in general prices and employment will increase and unemployment rates will decrease. In the CEECs the budget and the external accounts, both the trade and the current accounts, deteriorate (Table 7.2). Single Market effects The enlargement of the Single Market will result in increased competitive pressure for the accession countries and – to a lesser degree – the EU-15. Based on past experience, this is likely to cause an increase in productivity

194

Table 7.2 Integration effects of EU enlargement, Real GDP, 2005–10 (cumulative deviations from baseline, per cent)

Trade effects A Germany France Italy United Kingdom Spain Netherlands Belgium Sweden Austria Denmark Finland Ireland Portugal EU-13 Poland Hungary Czech Republic Eastern Europe

0.15 0.02 0.09 0.01 ⫺0.06 0.08 0.06 0.04 0.20 0.07 0.07 0.07 0.04 0.07 1.95 3.95 1.79 0.94

B 0.01 0.12 0.16 ⫺0.06 ⫺0.11 0.17 0.09 0.06 0.14 0.07 0.08 0.20 0.12 0.05 2.47 4.20 2.84 1.23

Single Market effects

FDI flows to CEEC

A

B

A

0.50 0.21 0.46 0.22 0.48 0.72 0.31 0.65 0.59 0.35 0.52 0.64 0.68 0.40 1.23 1.58 1.02 0.53

0.37 0.27 0.49 0.19 0.37 0.31 0.40 0.04 0.64 0.10 0.55 0.77 ⫺0.12 0.33 2.07 1.25 0.54 0.62

⫺0.07 ⫺0.10 ⫺0.04 ⫺0.01 ⫺0.11 ⫺0.08 ⫺0.06 ⫺0.06 ⫺0.09 ⫺0.07 ⫺0.09 ⫺0.14 ⫺0.09 ⫺0.07 0.21 0.32 0.14 0.08

B ⫺0.12 ⫺0.21 ⫺0.09 0.02 ⫺0.41 ⫺0.21 ⫺0.21 ⫺0.16 ⫺0.29 ⫺0.21 ⫺0.33 ⫺0.40 ⫺0.14 ⫺0.16 0.45 0.81 0.37 0.19

Migration to EU

Costs of enlargement

Total effects

A

B

A

B

A

B

0.06 0.03 0.02 0.03 0.04 0.05 0.03 0.07 0.13 0.02 0.05 0.05 0.05 0.05 0.02 0.03 ⫺0.03 0.01

0.23 ⫺0.03 ⫺0.03 0.05 0.05 ⫺0.08 ⫺0.02 ⫺0.02 0.16 ⫺0.05 0.02 ⫺0.05 ⫺0.12 0.06 ⫺0.12 ⫺0.09 ⫺0.08 ⫺0.04

⫺0.01 ⫺0.05 ⫺0.03 ⫺0.02 ⫺0.08 ⫺0.06 ⫺0.01 0.00 0.00 ⫺0.01 ⫺0.02 ⫺0.15 ⫺0.05 ⫺0.03 1.87 1.45 1.10 0.61

⫺0.01 ⫺0.04 ⫺0.03 ⫺0.02 ⫺0.07 ⫺0.04 ⫺0.01 0.00 0.01 ⫺0.02 ⫺0.02 ⫺0.13 0.05 ⫺0.03 3.15 2.23 1.98 1.08

0.63 0.10 0.50 0.24 0.28 0.71 0.33 0.69 0.83 0.35 0.53 0.47 0.63 0.42 5.26 7.32 4.03 2.16

0.48 0.11 0.50 0.18 ⫺0.18 0.15 0.26 ⫺0.07 0.66 ⫺0.11 0.31 0.40 ⫺0.21 0.26 8.02 8.40 5.65 3.07

Notes: A ⫽ average in 2005–6; B ⫽ average in 2008–10. Eastern Europe ⫽ Bulgaria, the Czech Republic, Hungary, Kazakhstan, Poland, Romania, Russia, Slovenia and Ukraine. Source: Own simulations using the OEF World Macroeconomic Model.

Fritz Breuss 195

(through the exploitation of economies of scale) and a decrease in prices (via a decrease in mark-ups), resulting in improved growth potential in the CEECs and the EU-15 alike. Such effects are dealt with in the theory of monopolistic competition (of the Dixit–Stiglitz type; economies of scale, product variety and so on). In macroeconomic models Single Market effects are captured by shocks to productivity and/or reduced mark-ups (or an immediate fall in price levels). Here we calculate Single Market effects in terms of increased efficiency (economies of scale) and reduced consumer prices (a similar methodology has been used by Catinat et al. (1988) to estimate the impact of the Single Market programme); these two effects are considered separately, although in practice both are interwoven. Model inputs – productivity shock We assume that the productivity shock and price competition experienced by the CEECs when they enter the EU will be similar or even stronger than they were when the old EU members created the Single Market in 1993. As benchmarks we take the ex-ante expectations that prevailed upon the creation of the Single Market (Catinat et al., 1988) and the ex post experiences of single countries (for Austria see Breuss, 2000a); that is, for the new members the productivity shock will amount to 2–3 per cent in the medium term and the initial shock to labour productivity will be 1.5 per cent, increasing to about 3 per cent after six years. For the EU-15 we assume there will be a much weaker productivity shock. According to the so-called ‘Casella effect’, ‘if economies of scale imply that firms located in large countries enjoy lower costs, then the gains from enlarging the bloc will fall disproportionally on small countries, because the entrance of new members diminishes the importance of the domestic market and improves the small countries’ relative competitiveness’ (Casella, 1996, p. 389; Badinger and Breuss, 2002). Hence we assume that for the small member countries there will be an initial productivity shock of about 0.75 per cent, decreasing over time, while for the large member countries the shock will be only half that magnitude. Model results – productivity shock Due to the probable asymmetry of productivity shocks, real GDP will develop better in small EU countries: Belgium, Austria, Finland and Ireland will see a slowly decreasing cumulative increase of 0.5 per cent until 2010, while the large countries will experience an increase of only half that size. However with increased labour productivity, employment will decrease and unemployment will rise. Improved labour productivity also implies a redistribution of income from labour to capital. Similarly with improved competitiveness, measured by the real exchange rate (relative unit labour costs), prices will fall and therefore nominal GDP will decline somewhat, with negative consequences for the budget.

196 EU Enlargement as an Economic Challenge

Due to the higher productivity shock that will be experienced by the CEEC-3, the macro effects will be similar in structure to those described for the old EU member states, but much larger in size. Real GDP will increase by approximately 1 per cent (cumulatively between 2005 and 2010), although with a different time pattern in each of these countries (see Table 7.2 above). Model inputs – price competition The increase in price competition in the enlarged Single Market will be stronger in the new member states than in the old ones. Similar to the ex ante expectations of the Single Market in 1993, we assume a decrease in the price level (measured by the consumer price index) of around 6 per cent over six years (or 1 per cent per annum) in the CEEC-3. For the present EU members we assume the additional price competition will be much weaker and will depend on the intensity of their trade with the CEECs. The price reductions are therefore calibrated according to trade weights, meaning that EU countries with more than 4 per cent trade with the CEECs will be confronted with a price decrease of 0.5 per cent per annum, and countries with less than 4 per cent trade with the CEECs will see a price decrease of only 0.15 per cent. Model results – price competition Increased price competition will result in greater demand and therefore in an increase in real GDP – initially about 0.5 per cent for EU countries with more intensive trade with the CEECs and around half of that for the other EU countries. The initial impact on real GDP will be similar: approximately 1 per cent for Poland and Hungary but only half that for the Czech Republic. Over time the GDP effect will remain high in Poland but will decline in Hungary and the Czech Republic. Other macroeconomic performances will be little affected by this price competition shock (see Table 7.2). Factor movements The four freedoms of the Single Market (the free movement of goods, services, capital and labour) imply that factor movements connected with EU enlargement can be placed under the heading ‘Single Market effects’. In most studies factor movements are either not considered at all or only partially. Therefore capital movements from West to East and labour migration from East to West are analysed here using the OEF world macroeconomic model. Model inputs and results 1. FDI flows from West to East: (a) inputs Since the process of transition began in 1989, trade and foreign direct investment (FDI) have been the two main channels of integration. Hungary has attracted most of the FDI inflows per capita ($1764), followed by the Czech Republic ($1447) and Estonia ($1115). While Poland has attracted most FDI in absolute terms the

Fritz Breuss 197

per capita value is only $518. According to Gács (1999), in the future FDI flows to the CEEC-3 should increase by around 1.5 per cent of GDP. This will lead to capital accumulation, the renewal of capital stock and improved growth potential (see also the less conservative scenario in Baldwin et al., 1997). It is indisputable that the CEECs will attract more FDI when they join the EU (greater security for foreign investors will lead to a reduction of the risk premia), but this could reduce investment in the EU-15 (and/or the rest of the world) or have a dampening effect via higher interest rates. Here we assume an increase in the short-term interest rate in the euro zone of 0.05 per cent at the beginning of the FDI process in 2003 and rising to 0.2 per cent by the end of the process in 2010.2 The reasoning behind this is that additional capital demand in the EU is likely to push up interest rates, which will dampen investment in the EU countries. (b) Results In the capital exporting of the EU there will be a slight decline in real GDP of around 0.1 per cent in 2003 and up to 0.2 per cent in 2010, on average. Smaller countries will be worse hit than large countries. In the CEECs the impact on real GDP will be strongest in Hungary with up to 1 per cent, followed by Poland (0.75 per cent) and the Czech Republic (0.5 per cent). Increased capital movement after EU accession will therefore result in the CEECs gaining an FDI (welfare) surplus, while the EU countries will be confronted with an FDI (welfare) loss (see Table 7.2).3 2. Migration from East to West: (a) inputs The hottest political potato in the enlargement debate is migration. Despite denial by the candidate countries that extensive emigration will take place, the bordering states (Germany, Austria and the Scandinavian countries) fear that mass migration will severely affect their labour markets when the free movement of persons, and therefore labour, is granted to the new members. Indeed the much lower wages in the CEECs (40 per cent of the EU average) could induce mass migration, and therefore the border states have insisted on transitional arrangements in respect of the movement of persons.4 The migration statistics used in our model are based on the estimates by Boeri and Brücker (2000; see also DIW, 2000). Assuming that all the CEEC-10 join the EU at once, it is estimated that 335 843 people will migrate from the CEEC-10 to the EU-15 during the first year, of which the majority will go to Germany (65 per cent or 218 430 persons) and Austria (12.1 per cent or 40 547 persons). By 2010 it is expected that the inflow of migrants will have declined to 146 926. Here we adapt these figures to fit into our assumed time schedule for enlargement (2005 for the Luxembourg group and 2007 for the Helsinki group). In addition the figures are broken down in order to determine the likely flow of migrants from each of the CEEC-3 to the individual EU member states. It is predicted that in 2005, 143 700 persons will migrate from the CEEC-3 to the EU-15 (including 95 800 to Germany and 17 650 to

198 EU Enlargement as an Economic Challenge

Austria), declining to 72 100 in 2010 (48 000 to Germany and 8820 to Austria). We assume that about two thirds of these migrants will join the labour force. (b) Results In line with the relevant theory (see Borjas, 1995) the simulations for migration have produced the expected pattern of immigration surplus in the recipient countries (the EU-15) and migration losses in the sender countries (the CEECs). Because firms in the EU-15 will be able to produce more at a lower labour cost, real GDP will increase in those countries (by about 0.25 per cent in Germany 2010 and 0.15 per cent in Austria) while falling in the CEEC-3 by approximately 0.25 per cent. As measured by per capita GDP, by 2010 the immigration surplus will be slightly positive in Germany (0.2 per cent) and Austria (0.06 per cent) because the yearly flow of migrants will only amount to 0.1 per cent of the total population in Germany and 0.2 per cent in Austria at the beginning of the process and the number will reduce over time. As a consequence of the increase (decrease) in the labour supply the unemployment rate will initially rise (fall) in the EU-15 (CEECs), but over time the disequilibria in the labour market will vanish. Migration will also involve a redistribution of income, with a shift from wages to profits in the recipient countries and vice versa in the CEECs (see Table 7.2). The costs of enlargement for the EU and the benefits for the CEECs The cost of enlargement is another cause of headaches for EU citizens. A starting point to integrate the costs of enlargement of the CEECs and the distribution of these costs across the EU-15 into the model simulations is the Agenda 2000, which was agreed upon by the heads of state and government at a special European Council Meeting in Berlin in March 1999. Agenda 2000 included a financial forecast for the period 2000–6. This assumed that the Luxembourg group would join the EU in 2002. It was estimated that the gross costs of enlargement (cumulatively over the period 2000–6, including preaccession costs) would amount to €80 billion (or 0.13 per cent of EU GDP, rising to 0.22 per cent in 2006). Deducting the resources that the Luxembourg group would have to contribute to the EU budget (1.27 per cent of GDP), the net cost of enlargement would be about €60 billion, or 0.1 per cent of EU GDP (0.17 per cent in 2006). After determining the exact date of accession (1 May 2004) and the number of acceding countries (10) the European Council in Copenhagen in December 2002 agreed upon the cost of enlargement for the period 2004–6 (€38 billion or 0.16 per cent of EU GDP in 2006). Several adjustments have to be made to fit this cost picture into our enlargement scenario. First, we have to extend the financial period to the year 2010.5 Second, it is necessary to break down the average costs laid down in Agenda 2000 for each EU member state and to identify which transfers each of the three CEECs will receive during the period in question. Third, the costs have to be adjusted to our timetable for accession. Finally, Agenda 2000 did not include all the potential costs to the CAP (for example direct support payments).6

Fritz Breuss 199

Model inputs Agenda 2000 excluded an increase in the CEECs’ contributions from their own resources above the stipulated 1.27 per cent of GDP, which means that the costs of enlargement will have to be borne by the present EU member states in the form of lower transfers from the CAP and the Structural Funds. This implies that countries that have been net budgetary recipients may become net contributors. Agenda 2000 cut the transfers from the Structural Funds much more severely than those for the CAP, which means that the so-called cohesion countries – Greece, Ireland, Portugal and Spain – will bear the highest burden. Adding to the costs for the CAP (80 per cent due to direct support payments after 2006)7 results in cumulative net costs for enlarging by CEEC-10 over the period 2000–10 of around €190 billion (or 0.15 per cent of EU GDP; in 2010 they will be about €40 billion or 0.3 per cent of EU GDP).8 The CEEC-3 are likely to cost €134 billion over the same period (0.11 per cent of EU GDP, or 2.5 per cent of CEEC-3 GDP). The burden of the costs of enlargement for the majority of the EU-15 will be below the EU average (0.17 per cent of GDP in 2005–10), but the cohesion countries will bear a higher cost: Portugal 1.5 per cent of GDP, Greece 1 per cent, Ireland 0.75 per cent and Spain about 0.4 per cent. Hungary and the Czech Republic will receive transfers amounting to approximately 5.25 per cent of GDP in 2010, and Poland about 4 per cent. This implies a ceiling of 4 per cent of GDP in case of the Structural Funds, as agreed upon in Agenda 2000. The costs and/or transfers are implemented in the Oxford model by means of three macro variables: in the current account balance (deterioration in the EU countries, improvement in the CEECs), in the national budgets (deteriorating in the EU, improving in the CEECs) and as a stimulus to infrastructure investment (dampening demand in the EU, stimulating demand in the CEECs).9 Model results The deterioration of the EU’s budget balance and current account balance will be accompanied by a small decrease in real GDP in the EU-15. In the CEEC-3, however, not only will the budget and current account balances improve, but also, and more importantly, infrastructural investment will lead to higher real GDP. Real GDP could increase by about 3 per cent in Poland and more than 2 per cent in Hungary and the Czech Republic during the period 2001–10. However these estimates may be rather low as HERMIN-model evaluations of the Community Support Frameworks for the period 1989–99 found that GDP rose cumulatively 9.9 per cent higher in Greece and 8.5 per cent higher in Portugal than would have been the case in the absence of assistance. The figures were lower for Ireland (3.7 per cent higher) and Spain (3.1 per cent) (EU, 2001a, p. 131). The potential impact of the Structural Fund programme over the period 2000–6, according to

200 EU Enlargement as an Economic Challenge

simulations using the HERMIN model, could be an additional cumulative increase in real GDP of 6 per cent in Greece and Portugal, 4 per cent in Eastern Germany, 2 per cent in Spain and 1.5 per cent in Ireland. Between 2006 and 2010 the GDP effects will decline (EU, 2000, p. 215). The QUEST II model used by the European Commission (EU, 2000, p. 216) produced much lower estimates for 2000–9: an additional increase of real GDP of 2.5 per cent in Greece and Portugal, 1 per cent in Spain and 0.5 per cent in Ireland. Our estimates for the CEEC-3 lie somewhere in between these two extremes (see Table 7.2). Overall results – more winners than losers Due to the smallness of the economies involved in the EU enlargement process, on average the CEECs will gain around 10 times more from enlargement than the EU. Taking account of all the likely integration effects, Hungary and Poland will increase their real GDP by 8–9 per cent over a 10-year period (including the preaccession period: 2001–4), that is, nearly 1 per cent more than expected annual growth. The Czech Republic will gain a little less (5–6 per cent, or 0.5–0.75 per cent more than expected annual growth). On average the EU will gain around 0.5 per cent more real GDP during 2005–10, or about 0.10 per cent more than expected annual growth. Countries with close ties to the CEECs, such as Austria, Germany and Italy, will gain more than the EU average; Austria’s real GDP could increase by 0.75 per cent of GDP, or 0.15 per cent more than expected annual growth. On average both the EU and the CEECs will benefit from enlargement, but for some countries the costs will exceed the benefits, particularly Spain, Portugal and Denmark. After a while the initial positive growth effect on the EU’s GDP will cease (Figure 7.1). We have only analysed the effects on three CEECs and it is possible that enlargement by 10 or 12 countries might lead to slightly higher integration effects. Nonetheless, as these three CEECs account for approximately two thirds of the GDP of the CEEC-10 and have stronger trade links with the EU-15 than do the CEEC-10, on average we have probably captured the major part of the potential integration effects of EU enlargement. When evaluating the total integration effects, one has to exercise a degree of caution. Not all partial effects are easily quantifiable. While the quantification of EU transfers, FDI flows and migration flows is relatively robust, others (the Single Market effects – productivity and price competition) can only be evaluated with a wide margin of error. Moreover the individual effects will have different weights in different countries. In the case of Austria, which will probably be the biggest West European winner from enlargement, the Single Market effects could account for three quarters of the total GDP effects. Trade effects and immigration surplus will be much less significant, but FDI outflows and the costs of enlargement will have a negative impact on GDP. In Hungary, for instance, trade effects and EU

Fritz Breuss 201 (a) 1.00 Austria Germany

0.80

Italy

0.60

EU 0.40

United Kingdom

0.20

Spain

0.00 –0.20 –0.40 –0.60 2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

(b) 10.00 9.00

Hungary

8.00

Poland

7.00 6.00

Czech Republic

5.00 4.00

Eastern Europe*

3.00 2.00 1.00 0.00 2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Figure 7.1 Overall integration effects (real GDP) of EU enlargement: (a) EU; (b) CEEC, 2001–10 (cumulative deviations from baseline per cent) * Eastern Europe ⫽ Bulgaria, Czech Republic, Hungary, Kazakhstan, Poland, Romania, Russia, Slovenia and Ukraine. Source: Own simulations using the OEF World Macroeconomic Model.

budget transfers will be more important than the Single Market effects and FDI inflows. For Germany and Austria the predicted immigration surpluses might not be realized if they utilize the full seven-year transition period for the free movement of labour. Our results are quite similar to those of Brown et al. (1997). Using a world CGE model they predict a long-term real income gain of 7.3 per cent for the

202 EU Enlargement as an Economic Challenge

Czech Republic, 6.8 per cent for Hungary and 5.6 per cent for Poland, with a spillover effect for the EU of 0.2 per cent. Neck et al. (1999), using a world macro model, estimate only mild GDP effects for Eastern Europe (⫹1.6 per cent) and practically no effects for the EU, while at the other end of the spectrum Baldwin et al. (1997), using a world CGE model, predict a real income increase of 18.8 per cent in seven CEECs but only 0.2 per cent in the EU-15. Similar results have been obtained by Breuss (2000b) from a calibrated twobloc (EU-15 and CEEC-10) model that includes trade effects, direct growth effects (via total factor productivity growth), FDI effects, migration effects and budgetary effects (costs of enlargement). The major growth impulse will stem from an increase in total factor productivity, which will produce real GDP increases of 17 per cent in the CEEC-10 after 18 years, and of 2.8 per cent in the EU-15. Speedier integration of the CEEC-10 would lead to higher GDP and welfare in both regions. The European Commission (EU, 2001d, p. 39), using a mixed scenario and macro-model simulations, has produced similar results to ours. For the future economic performance of eight CEECs, three growth scenarios are assumed (depending on initial conditions, the macroeconomic policy framework and structural reform programmes). Due to enlargement (which is assumed to start in 2005), annual GDP growth could be higher by 1.3–2.1 per cent than in the ‘no-join’ baseline scenario. Given this growth impact (positive demand via trade) plus two supply impulses (migration effects and mark-up effects in the EU), it is estimated that the GDP of the EU-15 will grow by 0.5–0.7 per cent during 2000–9. Similarly Lejour et al. (2001), using a CGE model (‘WorldScan’), calculate that in 2020 real GDP will be higher by 0.26 per cent in the EU-15 (in Germany by 1.6 per cent, the United Kingdom by 0.1 per cent and the Netherlands by 0.2 per cent, but 0 per cent in France. Meanwhile GDP in Southern Europe will rise by 0.2 per cent and in the rest of the EU by 1.0 per cent). In the CEECs real GDP will rise considerably during the same period: in Hungary by an additional 9.6 per cent, Poland by 8.7 per cent, the CEEC-5 (Czech Republic, Hungary, Poland, Slovakia, Slovenia) by 2.1 per cent and the CEEC-7 (CEEC-5 plus Bulgaria and Romania) by 6.0 per cent. Whether the above effects will be realized will depend on political ability and the growth-enhancing factors included in endogenous growth theory. In the wake of earlier accessions some countries were more successful in realizing their growth potential than others, but only Ireland can be considered a real success story. After it joined the EU in the first enlargement its real per capita GDP grew 2.4 per cent faster each year than the EU average between 1973 and 2000. In contrast, after Greece acceded to the EU in 1981 its real per capita GDP grew by 0.8 per cent less per annum than the EU average between 1981 and 2000. A better performance was recorded by Portugal and Spain after the second southern enlargement in 1986. Their real per capita GDPs respectively grew 1.0 per cent and 1.6 per cent faster than the EU average from 1986.

Fritz Breuss 203

The growth performance of the new members after the most recent EU enlargement (1995) was mixed: Finland’s and Sweden’s real per capita GDP respectively grew 2.3 per cent and 0.6 per cent faster than the EU average from 1995, in contrast with Austria’s ⫺0.04 per cent (see also Breuss, 2003b). Econometric tests of integration effects based on new growth theory have found that European integration efforts since the Second World War have led to an increase of real per capita GDP of 0.4 per cent per annum – 0.27 per cent from GATT liberalization and just 0.12 per cent from EU integration proper (Badinger, 2001, 2003).10

One- or two-step integration? Possible dangers of enlargement There are two approaches to the next EU enlargement. One school – represented by independent researchers such as Gros (2000) – would prefer one-step integration and advocate that entrants participate in the Single Market and EMU from the very beginning. Indeed Gros envisages ‘one euro from the Atlantic to the Urals’, or the ‘euroization’ of Europe. According to this view, immediate participation in the common currency would put strong pressure on the new member countries to stabilize, which in turn would lead to synchronization of the business cycles. This would create a situation where a country would be more likely to satisfy the criteria for entry into an optimum currency area (OCA) ex post rather than ex ante (for this argument see Frankel and Rose, 1998).11 However participation in EMU depends less on the OCA criteria than on the Maastricht convergence criteria, which the CEECs do not yet satisfy, particularly with regard to price stability and the interest criterion. The official approach – as espoused by the ECB (2000, pp. 114–18) and discussed at the ECOFIN Council meeting on 7 November 2000 (EU, 2001b) – favours a two-step integration of the CEECs. However the ECOFIN Council, in a statement on the implications of the accession process for exchange rate arrangements in the candidate countries, identified three distinct stages for the full monetary integration of candidate countries. First, during the preaccession stage (choice of an exchange rate regime) policy should be oriented towards achieving real and nominal convergence, fulfilment of the Copenhagen economic criterion (‘the existence of a functioning market economy able to cope with competitive pressures and market forces within the Union’). Second, during the accession stage new member states should treat their exchange rate policy as ‘a matter of common interest’ (EC Treaty, Article 124), there should be no competitive devaluations, the candidate countries will enter the EU as member states with a derogation in respect of EMU but an obligation to co-ordinate their economic policies and work towards meeting the Maastricht convergence criteria. Third, at some point during the postaccession period the new member countries will be required to join ERM-II, which offers stable but

204 EU Enlargement as an Economic Challenge

adjustable central rates to the euro for the participating currency, with fluctuation bands of 15 per cent above or below the central rate; countries with a currency board pegged to the euro may also join ERM-II. The new member states are thus supposed to adopt the euro in a manner that ensures equal treatment with the initial participants in the euro area. Our findings on the macroeconomic impact of CEEC accession and access to the Single Market strongly support the official doctrine. The partial integration effect and the total outcome reveal a consequence that is not usually considered in purely trade-oriented debates on enlargement – that EU enlargement will involve asymmetric shocks that will be more pronounced in new member states than in the incumbent countries. There will be different supplyside shocks (productivity/price shocks via the Single Market effects, and factor movements – in the form of labour migration and FDI flows) and demand shocks (trade effects and indirect effects of the costs of enlargement). In the 1990s a strong price convergence characterized the run-up to the third stage of EMU Figure 7.2). The accession of the CEECs will only cause a slight increase in inflation volatility, but if they were to adopt the euro immediately inflation volatility would increase considerably (Figure 7.3). Although the Single Market effects will increase overall price stability, the latter will vary from country to country throughout the expanded EU, so quick adoption of the euro by accession countries would make it difficult for

4.00 3.50 3.00 EU-15

Euro-12

2.50 2.00 1.50 1.00 0.50 0.00 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Figure 7.2 Inflation convergence in the EU in the run-up to EMU, 1992–2002 (standard deviation of CPI inflation rates)

Fritz Breuss 205 1.20 1.00

CEEC-3

EU-18

0.80 0.60 EU-15

0.40 0.20 0.00 2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Figure 7.3 Increased inflation volatility due to EU enlargement, 2001–10 (standard deviation of CPI inflation rates)

the ECB to run a central monetary policy for the ‘average’ inflation country in the eurozone, especially if it stuck to its present 2 per cent inflation target. In contrast to price convergence, the short history of EMU has not included strong synchronization of the eurozone business cycle (Figure 7.4),12 and immediate integration of the CEECs would reduce the likelihood of achieving this in the near future. The enlargement effects will increase GDP growth volatility much more strongly in the CEECs than in the EU-15 (Figure 7.5) and not all of the EU-15 will gain to the same extent, but the overall effect will be smaller if the two-step approach is adopted. Eurozone membership has not only led to a price and interest rate convergence, but also the budgetary position can improve considerably in the run-up to the third stage of EMU. This results from the necessity of meeting the Maastricht convergence criteria, and thereafter due to pressure exerted by the Stability and Growth Pact (Figure 7.6). After their accession the CEECs will profit from being net receivers and will therefore be able to improve their budgetary position. In the 1990s, while internal (budgetary) stability improved after the launch of EMU the external (current account) positions of the euro countries and the EU-15 as a whole diverged (Figure 7.7). Besides the detrimental effects of the oil price hike, this primarily reflected the costs of adjusting to the single currency in the eurozone, especially in those countries which had previously devalued their currencies in the event of current account difficulties (for example Greece, Italy, Spain and Portugal). As a heritage of the transition process, when the CEECs join the EU their current accounts

206 EU Enlargement as an Economic Challenge 3.20 3.00 2.80 2.60 Euro-12

2.40 2.20

EU-15

2.00 1.80 1.60 1.40 1.20 1.00 0.80

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Figure 7.4 GDP growth convergence in the EU in the run-up to EMU (no European business cycle), 1992–2002 (standard deviation of real GDP growth rates)

1.40 1.20 CEEC-3 1.00 0.80 0.60

EU-18

0.40 0.20

EU-15

0.00 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Figure 7.5 Estimated increase in GDP growth volatility due to EU enlargement, 2001–10 (standard deviation of real GDP growth rates)

will generally exhibit a deficit. In part these deficits are likely to be compensated by FDI inflows. Participation in the Single Market will worsen the current account position of Hungary but improve it in the Czech Republic and Poland (Table 7.3). Most of the CEECs have already oriented their exchange rate policies towards the euro, either by explicitly linking their

Fritz Breuss 207 4.00 3.50 3.00 2.50

Euro-12

EU-15

2.00 1.50 1.00 0.50 0.00 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Figure 7.6 Budgetary convergence in the EU in the run-up to EMU, 1992–2002 (standard deviation of budget balance, percentage of GDP)

5.50 5.00

Euro-12

4.50 4.00

EU-15

3.50 3.00 2.50 2.00 1.50 1.00 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Figure 7.7 Increased current account divergence in the EU in the run-up to EMU, 1992–2002 (standard deviation of current account balance, percentage of GDP)

currencies to the euro (in the form of a currency board) or by voluntarily pegging their currencies to the euro (Table 7.4). An ongoing dilemma in the CEECs concerns the so-called Balassa– Samuelson effect.13 On the one hand catching up with the real per capita GDP levels of the EU countries implies a permanent real appreciation (this also emerged from our enlargement simulations – see Table 7.3, in which an

208

Table 7.3 Macroeconomic effects of EU enlargement in selected countries, 2005–10 Germany A

Italy

B

UK

Spain

A

B

A

B

A

Austria A

B

B

Cumulative deviations from baseline in %: GDP, real GDP, nominal GDP per capita, real Personal disposable income, nominal Personal disposable income, real Consumer prices Employment, total Productivity (GDP/employment) Relative ULC (real effective exchange rate)

0.63 0.70 0.52 0.32 0.73 ⫺0.42 0.09 0.53 ⫺0.16

0.48 0.63 0.41 0.33 0.76 ⫺0.43 0.47 0.01 1.36

0.50 0.37 0.49 0.10 0.69 ⫺0.59 ⫺0.15 0.63 ⫺0.47

0.50 ⫺0.36 0.49 ⫺0.29 1.04 ⫺1.33 0.02 0.48 ⫺0.09

0.24 0.18 0.23 0.01 0.15 ⫺0.06 ⫺0.28 0.51 ⫺0.09

0.18 ⫺0.13 0.17 ⫺0.24 0.25 ⫺0.31 0.08 0.10 ⫺0.41

0.28 0.08 0.27 ⫺0.02 0.30 ⫺0.33 ⫺0.35 0.61 ⫺0.17

⫺0.18 ⫺0.30 ⫺0.18 ⫺0.40 ⫺0.02 ⫺0.41 ⫺0.55 0.36 0.83

0.83 0.82 0.62 0.52 1.35 ⫺0.84 ⫺0.37 1.20 ⫺0.18

0.66 0.11 0.54 ⫺0.22 1.21 ⫺1.42 ⫺0.04 0.72 ⫺0.01

Cumulative deviations from baseline in percentage points: Unemployment rate Current account (% of GDP) Budget balance (% of GDP) Short-term interest rate (%)

0.11 0.04 0.11 ⫺0.18

⫺0.21 0.24 0.29 0.72

0.15 ⫺0.05 0.10 ⫺0.18

0.06 ⫺0.21 0.00 0.72

0.28 0.04 ⫺0.07 0.13

⫺0.05 0.21 0.12 0.20

0.32 ⫺0.33 ⫺0.06 ⫺0.18

0.53 ⫺0.15 ⫺0.23 0.72

0.60 ⫺0.04 0.12 ⫺0.18

0.20 0.40 0.25 0.72

Poland

Cumulative deviations from baseline in %: GDP, real GDP, nominal GDP per capita, real Personal disposable income, nominal

Hungary

Czech Republic

A

B

A

B

A

B

5.26 4.21 5.52 3.68

8.02 1.87 8.18 1.66

7.32 7.67 7.56 7.06

8.40 8.49 8.54 9.60

4.03 2.60 4.18 2.81

5.65 ⫺2.31 5.75 0.76

Personal disposable income, real Consumer prices Employment, total Productivity (GDP/empl.) Relative ULC (real effective exchange rate)

5.66 ⫺1.97 0.45 4.83 3.04

9.87 ⫺8.14 1.71 6.30 5.51

8.16 ⫺1.11 0.42 6.91 4.69

12.20 ⫺2.77 0.82 7.56 3.57

5.72 ⫺2.88 ⫺0.54 4.58 4.85

11.36 ⫺10.62 0.40 5.22 10.42

Cumulative deviations from baseline in percentage points: Unemployment rate Current account (% of GDP) Budget balance (% of GDP) Short-term interest rate (%)

⫺0.63 3.07 2.48 ⫺3.95

⫺1.33 4.87 6.12 ⫺4.26

⫺0.52 ⫺1.04 4.56 ⫺1.46

⫺0.39 ⫺5.28 3.85 5.81

0.43 3.09 0.83 2.04

⫺0.15 3.57 1.90 5.54

Notes: A ⫽ average of 2005–6; B ⫽ average of 2008–10. Source: Own simulations using the OEF World Macroeconomic Model.

209

Table 7.4 Maastricht convergence criteria, candidate countries, 2000–1 (preconditions for entering EMU) Government budgetary position Inflation, CPI (HICP)1 (% change, 2001)

Deficit (% of GDP, 2001)

Debt gross (% of GDP, 2000)

Foreign debt, whole economy (% of GDP, 2000)

60.0

–

Exchange rates (% change vis à vis Euro, 20012

3.5 (3.3)

⫺3.0

Bulgaria Czech Republic

7.5 4.6

⫺0.9 ⫺7.1

76.9 17.3

81.8 21.4

No devaluation ⫹/⫺0.0 ⫺9.4

Estonia Hungary

5.9 9.1

⫺0.3 ⫺4.4

5.3 55.7

47.4 51.6

⫹/⫺0.0 ⫺3.0

2.5 1.4 5.6 34.1 7.4 8.5 9.2

⫺1.8 ⫺1.7 ⫺4.3 ⫺3.5 ⫺4.8 ⫺1.2 ⫺4.3

14.1 23.7 40.9 22.9 32.4 25.8 31.5

24.6 28.5 27.3 22.4 37.3 29.0 37.1

1.8 2.2 54.5 26.5 2.8 (2.8) 2.6 (2.5)

⫺2.6 ⫺5.4 ⫺19.6 ⫺9.7 ⫺1.1 ⫺0.5

63.0 60.6 57.8 38.2 68.8 62.5

174.3 318.8 50.1 70.3 – –

Reference value EU-15

Latvia Lithuania Poland Romania Slovakia Slovenia Transition accession countries Cyprus Malta Turkey Candidate countries Euro zone EU-15

exchange rate regime, 2001

Long-term interest rates (lending rate in %, 2000) 7.0

3

13.6 8.0

⫺5.0 ⫺14.4 ⫺9.6 ⫹114.0 ⫺1.5 ⫹17.6 –

CB (euro) Managed float (euro) CB (euro)3 Crawling peg (euro)4 Fixed peg CB (US dollars)3,5 Full float Managed float Managed float Managed float –

10.2 11.8 20.3 53.8 9.8 17.7 16.7

⫺0.7 – ⫹119.7 – – –

Managed float Managed float Free float – – –

6.0 7.4 51.2 17.8 5.0 5.0

8.9 13.1

Notes 1. HICP: harmonized index of consumer prices (in parentheses). 2. Most recent devaluation (⫹) or revaluation (⫺) against the euro since 1 January 1999. The candidate countries are not yet members of the Exchange Rate Mechanism (ERM-II). 3. CB ⫽ currency board. 4. Hungary extended the band of fluctuations against the euro from ⫹/⫺2.25% to ⫹/⫺15% on 4 May 2001. 5. Lithuania changed its anchor for the Litas from the US dollar to the euro on 2 February 2002.

Fritz Breuss 211

increase in per capita GDP goes hand in hand with a real appreciation). On the other hand these countries will require real depreciation in order to correct their current account positions and regain international competitiveness. The only feasible solution to this dilemma will be to improve productivity, particularly in the non-traded goods or service sectors. The Single Market integration effects could help in this regard. A negative aspect connected with the two-step integration solution would be a strengthening of integration à deux vitesses (flexible integration). If the two-step approach is adopted there will be more countries outside the eurozone (13 – the 10 new members plus Denmark, Sweden and the United Kingdom) than in it (12), and if the outsiders do not strictly link their currencies to the euro (which is demanded by the ERM-II system) competitive devaluations (as in the EMS crisis in 1992–93) could endanger the Single Market principle, which rests on fair competition.

Conclusions In this chapter the expected economic benefits of EU enlargement have been weighed against potential dangers. Our evaluation of EU enlargement using a world macroeconomic model has taken into account all possible integration effects: trade effects, Single Market effects, factor movements (FDI, migration) and the likely costs of enlargement. Due to the size differences between the regions concerned, in terms of real GDP the CEECs will gain about ten times more from enlargement than the EU-15. Hungary and Poland will increase their real GDP by 8–9 per cent over a ten-year period, the Czech Republic by a little less (5–6 per cent). On average the EU-15 will gain approximately 0.5 per cent of real GDP over a six-year period, but this average conceals winners and losers, with Austria, Germany and Italy gaining the most and losses being made by Spain, Portugal and Denmark. Hence EU enlargement will act like an exogenous shock, causing asymmetric disturbances in the EU. This could halt the process of business cycle synchronization and impair monetary policy in the eurozone. Integration of the CEECs in two steps (participation in the Single Market upon entry and only later participation in EMU) will therefore be preferable if macroeconomic stability is to be achieved in the eurozone. Notes 1. This work is based on Breuss’s (2001) simulations of the macroeconomic impact of EU enlargement. 2. How large the interest rate effect will be is unknown. Bartolini and Symansky (1995) investigated the macroeconomic impact of a sustained annual capital transfer of $70 billion from Western to Eastern Europe and found that the long-term interest rate would increase by 0.5 per cent. Neck and Schäfer (1996) conducted a similar experiment and found that an annual capital transfer of $35 billion from West to East would increase the long-term interest rate in Germany by 0.2 per cent.

212 EU Enlargement as an Economic Challenge

3.

4.

5. 6.

7.

8. 9.

10.

11.

In our study the following additional capital demand to finance the equivalent FDIs from West to East is assumed: in 2003 the three CEECs will attract additionally $330 million, increasing to $8435 million in 2010 (or a cumulative total of $28 596 million over this period). The assumed interest rate effect in Europe therefore lies in the range of those in the abovementioned studies. These results have to be seen in connection with the reorientation of FDI flows from the old EU member states (primarily from the cohesion countries) to the new member states due to the reform of the Structural Funds required by enlargement (see the next section). According to Braconier and Ekholm (2001) the opening up of the East after 1989 resulted in FDI being diverted from high-wage countries in the EU to low-wage countries in Central and Eastern Europe. Employment in EU multinational firms decreased, with a consequent rise in the CEECs. In 2001 the European Commission (EU, 2001c) suggested five options for the free movement of workers after enlargement: (1) full and immediate application of the acquis; (2) the adoption of safeguard clauses; (3) the introduction of flexible transitional arrangements (differing by country with evaluations being conducted after an introductory phase); (4) the establishment of a fixed quota system (with access to the labour market being limited at the EU, national, regional and sectoral levels); (5) non-application of the acquis for a limited period. Germany and Austria favoured a transitional arrangement for seven years while the Commission preferred a general transitional period of five years, plus an additional two years for countries that would need to protect their labour markets. It was agreed that EU member states could adopt a seven-year transition period or refrain from it. The negotiations for the period 2007–13 will take place in the 2005–6, at which time the exact costs of the enlarged EU will be determined. In its proposal for the accession negotiations, in January 2002 the European Commission suggested that direct payments to the new EU members should be phased in, with 25 per cent being paid in 2004 and a gradual increase to 100 per cent over 10 years (EU, 2002a). It was assumed that 10 candidate countries would join the EU in 2004 (in contrast to the earlier assumption that six countries would join in 2002). Accordingly the gross cost of enlargement in 2004–6 would amount to €40 billion, of which €26 billion would be for structural operations and only €10 billion for agriculture (of which only €2.6 billion would be in direct payments). This would equal 0.17 per cent of EU GDP. The mid-term review of the CAP (EU, 2002b) aims at fundamentally reforming the CAP. The direct payments would be uncoupled from production and capped and many other steps would relieve the agricultural budget. Similar results have been produced by the DIW (2000) and Weise (2002) with and without reform of the CAP and the Structural Funds. Breuss et al. (2001, 2002) have shown theoretically and empirically that Agenda 2000’s structural policy reform will lead to a considerable redirection of FDI from the EU cohesion countries to the new member states. According to Crespo-Cuaresma et al. (2002) the growth effect of EU membership increases with the length of membership and poor EU countries (the cohesion countries) have a higher EU membership growth effect (0.09) than the EU average (0.04). This can be seen as justifying our assertion that the poorer CEECs will gain more from EU enlargement than the richer EU-15 countries. Some authors (for example Artis and Zhang, 1999) assert that exchange rate stability in the EMS led to a stronger synchronization of the European business cycle (or at least a reduction of the association with the US cycle and a stronger correlation

Fritz Breuss 213 with the German cycle), but Inklaar and de Haan (2001) can find no relationship between exchange rate stability (measured during the EMS period) and business cycle synchronization. 12. This endorses the finding by Inklaar and de Haan (2001). 13. There is no consensus on whether a Balassa–Samuelson effect actually exists (for example Faria and León-Ledesma, 2001, can find no significant long-term relationship between the relative price ratios of major industrial countries and their per capita GDP ratios); but if it does, in the case of the CEECs it would not be easy to determine its magnitude. Kröger and Redonnet (2001) assume that the catchingup process in the CEECs will result in an inflation rate increase of 4 per cent a year. The Deutsche Bundesbank (2001, p. 25) estimates that annual real appreciation in the CEECs due to the Balassa-Samuelson effect (an improvement in labour productivity vis-à-vis the EU) was in the region of 1.9–2.6 per cent over the period 1994–99. Broeck and Slok (2001) put the figure at 1.4–2.0 per cent, Halpern and Wyplosz (2001) at 2.9–3.1 per cent and Coricelli and Jazbec (2001) at 0.7–1.2 per cent. In 1997–99 the CEEC-10’s real exchange rates appreciated by about 4 per cent per annum (or 3.3 per cent if Bulgaria and Romania are excluded). Given these estimates, the Balassa–Samuelson effect seems to be responsible for half of the appreciation of the CEEC currencies in recent years (see also Deutsche Bundesbank, 2001, p. 25) (for an overview, see Breuss, 2003a).

References Artis, M. J. and W. Zhang (1999) ‘Further evidence on the international business cycle and the ERM: is there a European business cycle?’, Oxford Economic Papers, vol. 51, pp. 120–32. Badinger, H. (2001) ‘Growth Effects of Economic Integration – The Case of the EU Member State’, IEF Working Paper no. 40 (Vienna: IEF, December). Badinger, H. (2003) Wachstumseffekse der Europaischen ˙ Integration (Vienna-New York: Springer). Badinger, H. and F. Breuss (2002) ‘Do small countries of a trade bloc gain more of its enlargement? An empirical test of the Casella effect for the case of the European Community’, IEF Working Paper no. 46 (Vienna: IEF, October). Baldwin, R. E., J. F. Francois and R. Portes (1997) ‘The costs and benefits of eastern enlargement: the impact on the EU and central Europe’, Economic Policy, vol. 24 (April), pp. 127–76. Baldwin, R. E. and A. J. Venables (1995) ‘Regional Economic Integration’, in G. Grossman and K. Rogoff (eds) Handbook of International Economics, vol. III (Amsterdam: Elsevier), pp. 1597–644. Bartolini, L. and S. Symansky (1995) ‘Macroeconomic Effects on Western Europe of the Opening Up of Eastern Europe: Some Simulation Results’, in P. de Fontenay, G. Gomel and E. Hochreiter (eds) Western Europe in Transition: The Impact of the Opening Up of Eastern Europe and the Former Soviet Union (Washington, DC: Banca d’Italia, International Monetary Fund and Oesterreichische Nationalbank, August), pp. 15–47. Boeri, T. and H. Brücker (2000) The Impact of Eastern Enlargement on Employment and Labour Markets in the EU Member States (Berlin and Milan: DIW, CEPR, FIEF, IGIER and IHS). Borjas, G. J. (1995) ‘The Economic Benefits from Immigration’, The Journal of Economic Perspectives, vol. 9, no. 2, pp. 3–22.

214 EU Enlargement as an Economic Challenge Braconier, H. and K. Ekholm (2001) ‘Foreign Direct Investment in Central and Eastern Europe: Employment Effects in the EU’, CEPR Discussion Paper no. 3052 (London: CEPR, November). Breuss, F. (1996) ‘Der aktuelle Stand der integrationstheoretischen Diskussion’, WIFOMonatsberichte, vol. 69, no. 8, pp. 525–44. Breuss, F. (1999) ‘Costs and Benefits of EU Enlargement in Model Simulations’ IEF Working Papers no. 33 (Vienna: IEF, June). Breuss, F. (2000a) ‘An economic evaluation of the economic effects of Austria’s EU membership’, Austrian Economic Quarterly, vol. 4, pp. 171–96. Breuss, F. (2000b) ‘The Role of Time in EU Enlargement’, in S. Arndt and H. Handler (eds) Eastern Enlargement: The Sooner, the Better? (Vienna: European Academy of Excellence and Austrian Ministry for Economic Affairs and Labour), pp. 118–32. Breuss, F. (2001) ‘Macroeconomic Effects of EU Enlargement for Old and New Members’, WIFO Working Papers no. 143 (Vienna: WIFO, March) (German version: ‘Makroökonomische Auswirkungen der EU-Erweiterung auf alte und neue Mitglieder’, WIFO-Monatsberichte 11/2001, pp. 655–66). Breuss, F. (2002) Kosten der Nicht-Erweiterung der EU für Österreich (Vienna: WIFO, March). Breuss, F. (2003a) ‘Balassa–Samuelson Effects in the CEEC: Are they Obstacles for Joining the EMU?’, IEF Working Paper no. 52 (Vienna: IEF, May). Breuss, F. (2003b) ‘Austria, Finland and Sweden in the European Union’, WIFO Austrian Economic Quarterly, vol. 4, pp. 131–58. Breuss, F., P. Egger and M. Pfaffermayr (2001) ‘The impact of Agenda 2000’s structural policy reform on FDI in the EU’, Journal of Policy Modeling, vol. 23, pp. 807–20. Breuss, F., P. Egger and M. Pfaffermayr (2002) ‘Structural Policy Reform and Distribution of FDI in Europe’, WIFO Working Papers no. 174 (Vienna: WIFO, February). Breuss, F. and F. Schebeck (1999) ‘Costs and Benefits of EU Eastern Enlargement for Austria’, WIFO Austrian Economic Quarterly, vol. 1, pp. 43–53. Broeck, M. de and T. Slok (2001) ‘Interpreting Real Exchange Rate Movements in Transition Countries’, IMF Working Paper, no. 01/56 (Washington DC: IMF, May). Brown, D., A. Deardorff, S. Djankov and R. Stern (1997) ‘An economic assessment of the integration of Czechoslovakia, Hungary, and Poland into the European Union’, in S. W. Black (ed.) Europe’s Economy Looks East. Implications for Germany and the European Union (Cambridge: Cambridge University Press), pp. 23–60. Casella, A. (1996) ‘Large countries, small countries and the enlargement of trade blocks’, European Economic Review, vol. 40, no. 2, pp. 389–415. Catinat, M., E. Donni and A. Italianer (1988) ‘The completion of the internal market: results of macroeconomic model simulations’, Economic Papers no. 65 (Brussels: European Commission, September). Corden, W. M. (1972) ‘Economies of Scale and Customs Union Theory’, Journal of Political Economy, vol. 80, pp. 456–75. Coricelli, F. and B. Jazbec (2001) ‘Real Exchange Rate Dynamics in Transition Economies’, CEPR Discussion Paper no. 2869 (London: CEPR, July). Crespo-Cuaresma, J. M., A. Dimitz and D. Ritzberger-Grünwald (2002) ‘Growth, Convergence and EU Membership’, OeNB Working Papers no. 62 (Vienna: Oesterreichische Nationalbank, 8 April). Deutsche Bundesbank (2001) ‘Währungspolitische Aspekte der EU-Erweiterung’, Monatsbericht (Frankfurt: Deutsche Bundesbank, October), pp. 15–31. DIW (2000) ‘EU-Osterweiterung: Keine massive Zuwanderung zu erwarten’, DIWWochenbericht, vol. 21 (May), pp. 315–32.

Fritz Breuss 215 Dixit, A. K. and J. E. Stiglitz (1977) ‘Monopolistic Competition and Optimum Product Diversity’, The American Economic Review, vol. 67, no. 3, pp. 297–308. ECB (2000) Annual Report 2000 (Frankfurt: ECB). EU (2000) ‘The EU Economy: 2000 Review’, European Economy, no. 71 (Brussels: Ecofin Council). EU (2001a) Unity, solidarity, diversity for Europe, its people and its territory (second report on economic and social cohesion, adopted by the European Commission on 31 January) (Brussels: European Commission). EU (2001b) ‘Exchange rate aspects of enlargement’, European Economy, no. 1, supplement C (Brussels: European Commission, Enlargement Directorate-General). EU (2001c) ‘The Free Movement of Workers in the Context of Enlargement’, information note (Brussels: European Commission, 6 March). EU (2001d) ‘The Economic Impact of Enlargement’, Enlargement Papers no. 4 (Brussels: Directorate General for Economic and Financial Affairs, European Commission, June). EU (2001e) Enlargement of the European Union: A historic opportunity (Brussels: European Commission). EU (2002a) ‘Common Financial Framework 2004–2006 for the Accession Negotiations’, information note SEC(202)102 final (Brussels: European Commission, 30 January). EU (2002b) ‘Mid-term Review of the Common Agricultural Policy’, communication from the Commission to the Council and the European Parliament, COM(2002)394 (Brussels: European Commission, 10 July). European Commission (1997) Agenda 2000: For a Stronger and Wider Union, Document KOM(97) (Brussels: European Commission, 15 July). Faria, J. R. and M. León-Ledesma (2001) ‘Testing the Balassa–Samuelson effect: Implications for growth and the PPP, paper presented at the 16th Annual Congress of the European Economic Association, Lausanne, 29 August–1 September. Frankel, J. A. and A. K. Rose (1998) ‘The Endogeneity of the Optimum Currency Area Criteria’, The Economic Journal, vol. 108 ( July), pp. 1009–25. Gács, J. (1999) ‘Macroeconomic Developments in the Candidate Countries with Respect to the Accession Process’, in P. Mayerhofer and G. Palme, Strukturpolitik und Raumplanung in den Regionen an der mitteleuropäischen EU-Außengrenze zur Vorbereitung auf die EU-Osterweiterung (Vienna: WIFO, December). Gros, Daniel (2000) ‘One Euro from the Atlantic to the Urals?’, CES-Ifo Forum, Summer, pp. 26–33. Halpern, L. and C. Wyplosz (2001) ‘Economic Transformation and Real Exchange Rates in the 2000s: The Balassa-Samuelson Connection’, Economic Survey of Europe, no. 1 (September) (Geneva: UN), pp. 227–39. Hoffmann, A. N. (2000) ‘The Gains from Partial Completion of the Single Market’, Weltwirtschaftliches Archiv, vol. 136, no. 4, pp. 601–30. Inklaar, R. and J. de Haan (2001) ‘Is there really a European business cycle? A comment’, Oxford Economic Papers, vol. 53, pp. 215–20. Keuschnigg, C., M. Keuschnigg and W. Kohler (1999) Eastern Enlargement to the EU: Economic Costs and Benefits for the EU Present Member States? Germany (Brussels: European Commission, September). Keuschnigg, C. and W. Kohler (1999) Eastern Enlargement to the EU: Economic Costs and Benefits for the EU Present Member States? The Case of Austria (Brussels: European Commission, September). Kohler, W. (2000) ‘Wer gewinnt, wer verliert durch die Osterweiterung der EU?’, in L. Hoffmann (ed.) Jahrestagung 1999: Erweiterung der EU, Schriften des Vereins für Socialpolitik (Berlin: Duncker & Humblot), pp. 27–77.

216 EU Enlargement as an Economic Challenge Kröger, J. and D. Redonnet (2001) ‘Exchange Rate Regimes and Economic Integration: The Case of the Accession Countries’, CES-Ifo Forum, Summer, pp. 6–13. Lejour, A. M., R. A. de Mooij and R. Nahuis (2001) ‘EU enlargement: Economic implications for countries and industries’, CPB Document no. 011 (The Hague: CPB, September). Madsen, A. D. and M. L. Sorensen (2002) ‘Economic Consequences for Denmark of EU Enlargement’, paper presented at the International Conference on Policy Modelling (EcoMod 2002), Brussels, 4–6 July. Martin, P. (1996) ‘A sequential approach to regional integration: The European Union and Central and Eastern Europe’, European Journal of Political Economy, vol. 12 (December) pp. 581–98. Neck, R., G. Haber and W. J. McKibbin (1999) ‘Macroeconomic Impacts of an EU Membership of Central and Eastern European Economies’, Forschungsbericht no. 9917 (Vienna: Ludwig Boltzmann Institut zur Analyse wirtschaftspolitischer Aktivitäten, October). Neck, R. and G. Schäfer (1996) ‘Gesamtwirtschaftliche Auswikrungen westlicher Kredite an die Reformländer’, in R. Holzmann and R. Neck (eds) Ostöffnung: Wirtschaftliche Folgen für Österreich (Vienna: Manzsche Verlags- und Universitätsbuchhandlung), pp. 155–92. OEF (2000) The Oxford World Macroeconomic Model – An Overview, Oxford Economic Forecasting (Oxford: OEF, March). Rodrik, D. (2001) ‘The Development Countries’ Hazardous Obsession with Global Integration’, paper presented at a lecture in Vienna on 21 February (reprinted in Foreign Policy, March/April 2001, under the title ‘Trading in Illusions’). Viner, J. (1950) The Customs Union Issue (New York: Carnegie Endowment for International Peace). Weise, C. (2002) ‘How to finance Eastern Enlargement of the EU’, Discussion Papers no. 287 (Berlin: DIW, June).

Part IV Experience of Previous Accessions and Lessons for CEECs

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8 Lessons to be Learnt from Earlier Accessions1 Kazimierz Laski and Roman Römisch

There is a vast body of literature on the topic of the EU’s eastward enlargement and the lessons that the five accession countries in Central and Eastern Europe (the Czech Republic, Hungary, Poland, Slovenia and Slovakia) can learn from the experience of the four cohesion countries (Ireland, Greece, Portugal and Spain).2 At the centre of these investigations are the supply-side effects of enlargement, mostly in a general equilibrium type of analysis. As a rule they neglect demand-side effects, although supply and demand are the two poles of every economic process. This chapter will take a more balanced approach in respect of capital inflows, especially foreign direct investment (FDI). Thus the first question to be addressed is the influence of capital inflows on the size of GDP and the external position of the cohesion countries. The second question is only indirectly related to the first and deals with the impact of EU accession on the growth of the cohesion countries and their convergence with the EU average. In both cases we shall look for conclusions that can be drawn with regard to the accession countries.

The influence of capital inflows on GDP and the external position of the cohesion countries Investment, in the sense of national accounting, is defined as an activity that replaces an old capacity with a new one. FDI has partly the same meaning, partly a different one. Thus FDI in the form of ‘greenfield investment’ and the expansion/modernization of existing capacity (sometimes called ‘brownfield investment’) is investment in the national accounting sense. In contrast the acquisition of a proportion of shares in existing enterprises (whether or not this is related to their privatization), mergers and similar activities are not investment in the national accounting sense but rather a special form of capital inflows that are often called non-debt-creating capital inflows (as opposed to credits). It is estimated that about half of the past FDI in the accession countries is not investment in the national accounting sense because the FDI-related privatization of existing capacity has been 219

220 Lessons from Earlier Accessions

extremely intense in these countries. In this sense the comparability of FDI in the accession countries and that in the cohesion countries suffers because in the latter group the FDI-related privatization of collectively owned assets has played a rather subordinate role. Nevertheless, even in the case of the cohesion countries we should not forget that statistical data on FDI do not necessarily represent investment in the national accounting sense. This distinction is important as the influence on the size of GDP of that part of FDI which represents investment and of that which does not, is not only different but may even go in the opposite direction. To elaborate this point, Equation 8.1 shows the factors that determine GDP from the demand side: GDP ⫽ (I ⫹ T)/s

(8.1)

where I, T and s respectively denote (gross) domestic investment, the trade balance (with goods and non-factor services) and the domestic savings ratio, defined as the relationship between domestic savings, S ⫽ I ⫹ T, and GDP. It should be stressed that in the theory of effective demand the causality runs from investment and trade balance to domestic savings and not in the opposite direction. Equation 8.1 can be used when capacity and labour force are not fully utilized, a situation that is quite normal in a capitalist economy. At the very centre of Equation 8.1 lies the income effect of investment; this is related to primary revenues earned by those involved in the execution of investment orders and to the chain of secondary expenditures on consumer goods financed from primary revenues. At given s and T, any increase in I causes an increase in GDP, which is a multiple of the investment increase; therefore the whole process is called an investment multiplier. The other factor in the numerator of Equation 8.1 is the trade balance: here too an increase in the trade balance at given s and I causes an increase in GDP, which is a multiple of the trade balance increase; therefore the whole process can be called a trade balance multiplier. There are, however, two important differences between I and T. Investment has a domestic capacity effect because it increases the existing production possibilities: it follows the income effect and materializes only when the income effect is gone. This effect does not exist in the case of the trade balance. The second difference is linked to the fact that I is always positive, although in an extreme case it may become zero. Thus the smaller that I is, the smaller the income effect of I, and it can never become negative. In contrast T may be positive (export surplus), zero or negative (import surplus). When there is an export surplus (T ⬎ 0) domestic savings are larger than domestic investment, and at given I and s the final output and employment are larger than they would otherwise be. Conversely with an import surplus (T ⬍ 0) domestic savings are smaller than domestic investment, and at given I and s the final output and employment are smaller than they would otherwise be. This is the main reason why capitalist countries try to become net

Kazimierz Laski and Roman Römisch 221 I, I + T

s

A B

0

Yb

Sa = I 0 C

Ya

Sb = I0 + T0

Y

Figure 8.1 GDP and capital inflows

exporters and avoid being net importers. In the first case they win jobs from the rest of the world, in the second they lose them to the rest of the world. This analysis brings us back to the role played by FDI and capital inflows in general in determining GDP from the demand side by influencing – at a given s – both I and T. Point A in Figure 8.1 represents the initial situation without any FDI. At domestic investment I0 and a zero trade balance (because the country is assumed to be capable of covering its import requirements via sufficient exports) we have domestic savings Sa ⫽ I0 and GDP ⫽ Ya. Now we shall introduce FDI and investigate two extreme solutions. In the first case FDI causes additional investment equal to ⌬I, hence investment amounts to I1 ⫽ I0 ⫹⌬I. We assume that the trade balance moves from zero to a deficit, T0 ⬍ 0, where |T0| denotes the import surplus and ⌬I ⫽ |T0|.3 In this case domestic savings and GDP will remain Sa ⫽ I1 ⫹ T0 and Ya, respectively; however the share of investment in GDP will increase and absorption will amount to Ya ⫹ |T0|. The other extreme possibility is that FDI inflows do not influence domestic investment at all but are one of the main causes of moving the trade balance into deficit at given I and s. Ample foreign capital inflows lead to real appreciation of the domestic currency, making export sales more difficult and imports cheaper. This real appreciation very often follows the use of the exchange rate as an anchor to fight inflation; indeed the idea that the nominal exchange rate should increase more slowly than the domestic price level implies, at given foreign prices, real appreciation as a direct consequence of a successful use of the foreign exchange anchor in the disinflation process. The other factor that may be responsible for a trade balance deficit that is not caused directly by capital inflows but is made possible by them is a change in the distribution of income. With growing income inequality there is a demand by

222 Lessons from Earlier Accessions

upper-income households for mostly imported luxury goods. All these factors increase the import intensity of GDP in the presence of ample capital inflows.4 Point B in Figure 8.1 represents the configuration just discussed. With domestic investment remaining at the initial level, I0, and a trade balance of T0 ⬍ 0, domestic savings are Sb ⫽ I0 ⫹ T0, Sb ⬍ Sa and GDP is equal to Yb, Yb ⬍ Ya. Not only is GDP (and of course employment) smaller in the second case than in the first, but also absorption (equal to Yb ⫹ |T0|) is smaller than Ya because, with 0 ⬍ s ⬍ 1, the segment |T0| ⫽ AC is smaller than the segment ⌬Y ⫽ Ya ⫺ Yb ⫽ BC. Point B may be interpreted as reflecting the influence of capital inflows falling exclusively on the trade balance, with no influence on domestic investment. The real development is probably between the two extremes represented by points A and B. On the one hand FDI causes additional investments, on the other hand it causes some deterioration of the trade balance. If ⌬I ⬍ |T0|, ⌬I ⬎ 0, T0 ⬍ 0, that is, domestic investment increases less than the import surplus, GDP will be greater than Yb but smaller than Ya because at a given savings ratio, s, aggregate demand will suffer, aggregate production will fall and so will employment. Countries that achieve an export surplus rightly claim that an increase in the trade balance, T0 ⬎ 0, creates jobs as their GDP will be greater than Ya. The other side of the coin, which is usually neglected in analysis, is the destruction of jobs in countries with an import surplus that is not fully compensated by an investment increase. Of course for all points lying between A and B, investment is higher than I0, as is the increase in capacity compared with the initial situation. When, however, this increased capacity is accompanied by a lower (or even the same) GDP, the degree of capacity utilization deteriorates, investment decisions may suffer and consequently future investment could as well. We have discussed the possible consequences that capital inflows can have upon aggregate demand, as well as the question of whether these inflows have an impact on domestic investment. In the long term, this is very important because domestic investment creates new capacities, and as a rule those related to FDI display high levels of technical and managerial efficiency in terms of labour productivity and product quality. Even when FDI is limited to privatization alone the consequences are as a rule similar, albeit somewhat belated. Although very important, the volume of domestic investment is only half of the problem. The other half relates to their structure. The special (and from our point of view decisive) question related to capital inflows, especially FDI, is their short- and long-term impact on foreign trade constraints in the host countries. In contrast to other forms of capital import, FDI plays a direct role in modernizing the economy, thus helping to bridge the technological gap between less and more developed countries. This is especially important when a drive towards modernization improves the foreign trade

Kazimierz Laski and Roman Römisch 223

situation by promoting export activities and reducing import requirements. It is, however, not clear whether foreign firms as a whole act along these lines or whether they constitute part of the problem. It is understandable that, in the investment phase, FDI inflows can have a rather negative impact on the trade balance because of the increased importation of capital goods. The real issue in relation to the impact of FDI on the balance of trade is the time at which new capacities are put into operation. Sooner or later foreign firms in a given country may become net exporters, however they may also ultimately remain net importers. In many cases major international corporations are interested in local markets, especially in larger countries. They export large quantities, but import large quantities as well. Being international they import components from elsewhere; in that sense they are import-intensive. It can thus happen that foreign firms as a whole not only fail to improve the balance of trade, but may even be responsible for a large part of the host country’s trade deficit. This situation may change over time for export-intensive firms, especially in the manufacturing sector. When, however, foreign firms are engaged in activities with a low degree of exportintensity (such as telecommunications, energy, banking and insurance, and retail trade), they will have a rather negative impact on the trade balance. Thus by treating all foreign firms as a separate sector, that sector will help to solve the country’s foreign trade difficulties only if it becomes a net exporter. This is the crux of the problem because sooner or later a capitalimporting country has to balance its trade and current account. Empirical data illustrating this analysis are difficult to present. In reality I and T are influenced by many factors, some of which may be more important than capital inflows. In addition the domestic savings ratio, s, does not remain constant, as assumed in Figure 8.1. Nevertheless it may be interesting to look at some relevant data. In Table 8.1 the most important data on the external position of the four cohesion countries are presented as averages for the last three decennia. The domestic investment ratio (I/GDP) declined in all the cohesion countries but Spain, where it remained constant over the 1980s and 1990s. The most marked decline between the 1980s and 1990s, some 3 per cent, occurred in Greece and Portugal. As far as the trade to GDP and current account to GDP ratios are concerned, the general picture is similar. Except for Ireland, which moved to a strong positive balance of trade and a slightly positive current account, the three other countries continued to report negative external positions. The balance of trade deteriorated in Greece by 3 per cent; in Portugal and Spain it remained more or less unchanged. The current account deteriorated by about 1 per cent in Portugal and Spain, but remained almost constant in Greece. Foreign deficits were covered mainly by FDI flows and net BoP inflows from the EU. In the 1990s FDI inflows as a percentage of GDP were (with the exception of Greece) higher than previously; in Portugal and Spain they accounted for 2.2 per cent and 2.3 per cent respectively, and in Ireland for

224 Table 8.1 External position of the cohesion countries, 1970–2000 (annual averages, percentage of GDP)

Ireland I/GDP T/GDP (I ⫹ T)/GDP FDI/GDP CA/GDP Funds/GDP1 Agricultural subsidies/GDP1 Total transfers/GDP1 Net BoP flows/GDP2 Greece I/GDP T/GDP (I ⫹ T)/GDP FDI/GDP CA/GDP Funds/GDP1 Agricultural subsidies/GDP1 Total transfers/GDP1 Net BoP flows/GDP2 Portugal I/GDP T/GDP (I ⫹ T)/GDP FDI/GDP CA/GDP Funds/GDP1 Agricultural subsidies/GDP1 Total transfers/GDP1 Net BoP flows/GDP2 Spain I/GDP T/GDP (I ⫹ T)/GDP FDI/GDP CA/GDP Funds/GDP Agricultural subsidies/GDP1 Total transfers/GDP1 Net BoP flows/GDP2

1970–79

1980–89

1990–2000

25.8 ⫺9.4 16.3 1.3 ⫺5.1

21.3 ⫺2.3 18.9 0.6 ⫺5.3 1.36 3.38 4.74 3.01

20.4 9.3 29.7 6.0 1.4 2.06 3.19 5.31 4.11

32.1 ⫺5.4 26.6 0.7 ⫺0.7

24.1 ⫺4.7 19.4 1.1 ⫺2.0 1.14 2.23 3.38 2.35

21.4 ⫺7.9 13.6 0.9 ⫺2.2 2.24 2.79 5.12 3.96

29.1 ⫺8.9 20.3 0.5 ⫺2.0

30.0 ⫺8.7 21.3 1.1 ⫺3.8 1.35 0.39 1.74 1.23

26.7 ⫺8.4 18.3 2.2 ⫺4.7 2.98 0.66 3.79 2.38

27.5 ⫺1.6 25.9 0.5 ⫺0.5

23.0 ⫺0.7 22.3 1.3 ⫺0.9 0.31 0.46 0.77 0.29

23.5 ⫺1.0 22.5 2.3 ⫺1.6 1.01 0.88 1.95 0.80

Notes 1. Mainly structural and cohesion funds; averages 1987–89, 1990–99. 2. Averages 1987–89, 1990–98. Sources: Ameco Database; World Investment Report, UNCTAD; Eurostat New Cronos database.

Kazimierz Laski and Roman Römisch 225

6.0 per cent. The cohesion countries also received sizeable transfers from the EU. In the 1990s gross transfers in relation to GDP were far higher than in the 1980s. They were higher in Ireland and Greece (above 5 per cent) than in Portugal and Spain (nearly 4 per cent and 2 per cent respectively). It should be added that some of these transfers were linked to the Structural and Cohesion Funds, and therefore to real investment. The Funds to GDP ratio amounted to about 2 per cent in both Greece and Ireland, almost 3 per cent in Portugal and just over 1 per cent in Spain. Thus in all four countries total FDI plus transfers related to domestic investment increased substantially in the 1990s. At the same time, as already mentioned, the share of I in GDP declined everywhere but Spain, where it remained almost constant. Post hoc non est propter hoc. Therefore we cannot argue that the drop in the I/GDP ratio was caused by the increase in the sum of FDI flows and EU transfers (in relation to GDP). Perhaps the drop in the investment ratio would have been even stronger without the latter inflows. It should be added that net flows from the EU to these countries were quite considerable. In the 1990s, in relation to GDP they amounted to 4.1 per cent in Ireland, 4 per cent in Greece and 2.4 per cent in Portugal. With the exception of Spain and all other things remaining equal, the current account to GDP ratios would have been much worse without them. Important developments are ignored when only decennial averages are investigated. Sometimes the time profile of certain variables deserves attention or events that are not registered in Table 8.1 should be taken into account in order to gain a better understanding of changes in the external position of the countries under examination. In Ireland the domestic investment ratio increased continuously between 1960 and 1973, as did the import surplus. This continued until the early 1980s, with the I/GDP and |T|/GDP, T ⬍ 0, ratios reaching record levels in 1979: 31.7 per cent and 16.4 per cent respectively. Ireland’s critical external position and its budget deficit of more than 10 per cent required a radical shift towards restrictive policies in the 1980s. GDP growth decelerated from about 5 per cent per annum in the 1960s and 1970s to only 2.8 per cent per annum in 1979–94. During the same period domestic investment stagnated and the investment ratio dropped to 16 per cent in 1994; thereafter the I/GDP ratio increased, reaching 28 per cent in 2001. The trade balance improved continuously after 1979, the year in which Ireland joined the ERM and broke its link with the British pound. While exports developed normally, imports – which in some years had increased quite strongly before 1979 – declined thereafter. This was due to the slowing of Ireland’s growth, but probably also to the strong depreciation of the punt against the British pound, the currency of Ireland’s main trading partner. The trade balance became positive in 1985 and recorded an average export surplus of over 10 per cent of GDP in 1995–2001. At the same time, given the enormous outflows of NFIfA (net factor income from abroad), the current account was more or less balanced.

226 Lessons from Earlier Accessions

Three important conclusions can be drawn from this overview. First, the foreign trade bottleneck manifested itself with great intensity in the 1970s. Second, large FDI inflows occurred when Ireland achieved a balanced foreign position. Third, Ireland joined EMU with an exchange rate that ensured satisfactory competitiveness within the EU. Indeed in 1995 the exchange rate of the punt (measured in terms of the Deutschmark) was a mere 80 per cent of its value in 1986.5 Since 1960 Greece has been an import surplus country. This surplus increased from about 3 per cent of GDP in 1960 to 9 per cent in 1965, but then diminished almost continuously until 1981, when it stood at about just 1 per cent of GDP. Since then it has mostly increased, and in 2000 it amounted to about 8 per cent of GDP. The current account shadowed this trend, and in some years around 1980 it even recorded a surplus. The critical year was 1990, when the foreign trade deficit was more than 9 per cent and the current account deficit was almost 5 per cent of GDP. One of the reasons for the deterioration of Greece’s foreign position may have been the drop in competitiveness in terms of the changes in relative unit labour costs (ULCs) measured in euros. In the period 1981–86 the increase in these costs in Greece was slower than in the EU-15. Thereafter, however, the opposite was the case: in 1987–91 and 1992–99 the increases were more rapid in Greece than in the EU-15 – by 0.5 and 2 per cent per annum respectively. This was accompanied by a real appreciation of the national currency, although the nominal exchange rate continuously depreciated. Only in 2000–1 was this trend reversed. According to Georgakopoulos (2001) other factors were partly responsible for these developments in the early postaccession years. Although Greece had been associated with the EU for 20 years, its imports were still strongly protected and its exports heavily subsidized. Whereas its tariffs were gradually aligned with the EU’s external tariffs, protection continued to increase in other guises, such as quantitative restrictions, advance deposit requirements, invoice controls, government procurement policies, and especially indirect taxes that blatantly discriminated against imports and afforded high protection to manufactured products by distinguishing artificially between luxury (imported) and non-luxury (domestic) goods. The mandatory abolition of this informal protection in the 1980s was bound to increase imports but it did not help exports, which had already been enjoying free access to the EU since 1968. On the contrary the abolition of the extensive subsidies for certain exports ruined their former (artificial) competitiveness. On the other hand some cheap Greek imports of meat and butter from third countries had to be replaced by expensive imports from EU countries, thus provoking a sharp increase in internal prices after accession. Georgakopoulos also discusses some problems relating to the huge transfers that the Greek economy has received from the EU budget. He argues that these resources have been partly offset by direct transfers through trade from Greek

Kazimierz Laski and Roman Römisch 227

consumers to EU producers. For example he points out that Greece is a net importer of cereals and animal products from other EU countries and a net exporter to EU consumers of Mediterranean products. Cereal and animal products, however, are supported by tariffs and levies, while Mediterranean products are mostly supported via the EU budget. He concludes that at the outset the budgetary transfers were offset to a large extent by direct trade transfers. With transfers increasing over time, direct trade losses rose to one third of the budgetary transfers. Nevertheless even the remaining transfers were of a considerable order: 2.5–3 per cent of GDP. The impact of this on the economy, was disproportionate to its size as the transfers mostly went to farmers and helped to finance excessive imports. Hence the transfers did not promote economic activity and employment. The structure of the funds, however, improved gradually by increasing investment in physical and human capital, and in 1995 this was conducive to a new phase of growth. In the period 1960–73 Portugal’s external position was stable, although it registered a growth rate of almost 7 per cent per annum. The import surplus mostly hovered around 5 per cent of GDP and in some years the current account even registered a surplus. At the end of this period the external position visibly deteriorated. In 1974–85 there was a marked slowdown in growth (related to the revolution of April 1974, which ended an authoritarian regime of 50 years’ standing), and the foreign position continued to deteriorate until about 1981, when the foreign trade and current account deficits reached some 16 per cent and 12 per cent of GDP respectively. In the following years the situation improved markedly, will the import surplus declining to 3.1 per cent of GDP in 1985 and the current account registering a small surplus. After 1985 GDP growth accelerated and, as could be expected, the external position deteriorated. Import surplus as a share of GDP rose from 3.1 per cent. to 7.4 per cent in 1994 and 12.1 per cent in 2000: an increase of 9 percentage points. The pattern of the current account deficit was similar to that of the trade deficit. One of the reasons for this deterioration was the decreasing competitiveness of Portugal’s economy, manifest in a relative increase in ULCs after accession. Indeed in 1981–86 ULCs increased by only 4.7 per cent per annum compared with 6.2 per cent in the EU-15. After 1986 the opposite was the case (in 1987–91, 1992–99 and 2000–1 in per cent per annum: 7.8 per cent versus 4.3 per cent, 2.1 per cent versus 1.7 per cent and 5.1 per cent versus 2.1 per cent respectively). However another factor may have played a role too. In 1986–2002, Portugal’s GDP growth rate of 3.5 per cent was approximately 1.1 per cent higher than in the EU; consequently Portugal’s imports surged ahead of exports, leading to a large foreign trade imbalance. Over the past 40 years the external position of Spain has been mostly stable. Its trade balance and current account have moved in parallel, with deficits following surpluses and vice versa. However the range has been rather limited – mostly between plus 2 per cent and minus 5 per cent of GDP in the

228 Lessons from Earlier Accessions

mid 1960s and mid 1970s. In 1980–85 Spain’s external position improved and attained a modest trade balance and current account surplus. After joining the EU its external position deteriorated abruptly by about 5 per cent of GDP; this was caused to a great degree by the real appreciation (almost 20 per cent) of the national currency in 1986–91. The financial crisis of 1992 followed soon after, although the foreign trade and current account deficits remained in the order of 3–4 per cent of GDP. This goes to prove that even minor external deficits in a medium-sized country can prompt a speculative attack on the national currency when capital markets are liberalized under conditions marked by major differences in inflation rates and the movement of relative ULCs. Indeed in 1980–86 ULCs, increased in Spain and the EU-15 by 3.4 per cent and 6.2 per cent per annum respectively, that is, in Spain they increased much more slowly than in the EU-15. In 1987–91 the situation was reversed: ULCs increased in Spain by 8.8 per annum. while in the EU-15 the increase was only 4.3 per cent per annum. The pronounced nominal and real depreciation of the national currency after the crisis of 1992 caused ULCs measured in EUR to remain constant in Spain in 1992–99 while in the EU-15 they increased by 1.7 per cent per annum. In the years immediately preceding the entry of Spain into EMU the Spanish peseta lost nearly one third of its value against the Deutschmark, so like Ireland, Spain joined EMU with a competitive exchange rate.6 This highlights the potential significance of sovereign decisions governing exchange rate policy when the financial position of a country takes an unexpected turn. On the other hand the accession countries would be well advised not to join the ERM and then EMU with a strong currency that is based not on a strong economy but on continuous capital inflows. It is rather difficult to draw general conclusions from this analysis. One can, however, say that apart from Ireland the cohesion countries’ external position did not improve. This can be seen in Figure 8.2, in which exports are measured as a percentage of imports. Indeed at the time of its accession Greece still covered 100 per cent of its imports by exports. From 1981 onwards the coefficient X/M declined almost systematically, and by 2000 it amounted to only 70 per cent. In Portugal this coefficient declined from 94 per cent in 1986 to 72 per cent in 2000. In Spain import coverage by exports improved significantly after the crisis in the early 1990s – whereas the coefficient stood at 111 per cent in 1986 it had fallen to 94 per cent by 2000. It should be stressed that at the time of their accession to the EU all three countries were able to cover their import expenditures by export revenues. Over time, however, they lost that ability to differing degrees. It is easy to imagine the difficulties that an applicant country with a coefficient X/M that was significantly below 100 per cent might encounter, as is the case with the present accession countries. The persistent trade balance and current account deficits experienced by some of the cohesion countries raise the question of their long-term financing.

Kazimierz Laski and Roman Römisch 229 120 110 100 90 80 70 60 50 40 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 Greece

Ireland

Portugal

Spain

Figure 8.2 Cohesion country exports as percentage of imports, 1960–2000

Disregarding FDI and net inflows from the EU, this financing implies foreign credits. Can they sustain a steady-state growth at a rate g, g ⬎ 0, if an import surplus |T|, T ⬍ 0, being a constant share t, 0 ⬍ t ⬍ 1, of GDP persists? In other words, can a country indebt itself every year by |T| ⫽ tGDP in order to finance its trade deficit as well as its debt service, denoted by iD, where i and D are the constant rate of interest and the accumulated foreign debt, respectively? It can be proven that under certain conditions ( g ⬎ i), foreign debt in relation to GDP will tend to reach a certain point at which it becomes constant. When the rate of interest is lower than the growth rate, i ⬍ g, the D/GDP ratio has a limit of t/( g ⫺ i). If, for example, t ⫽ 0.03, g ⫽ 0.05 and i ⫽ 0.03, the D/GDP ratio will tend towards the limit of [0.03/(0.05–0.03)] ⫽ 1.5. In other words foreign debt will increase in relation to GDP until it reaches the limit of 1.5, whereupon the ratio will stop increasing (and foreign debt will be 1.5 times greater than GDP). We can illustrate this situation using the following figures. With GDP equal to 100 and foreign debt equal to 150, the new credit required to finance the foreign trade deficit will amount to tGDP ⫽ 3, plus iD ⫽ 0.03(150) ⫽ 4.5 to service the foreign debt. Taken together the new credits will amount to 3 ⫹ 4.5 ⫽ 7.5, or exactly 5 per cent of the existing foreign debt of 150. Thus foreign debt will increase in pace with GDP, as initially assumed. This construction may seem strange. The rest of the world lends 7.5, of which 4.5 is used to pay the interest due on foreign debt to the rest of the world. If a single bank was involved, the latter would soon realize that it was funding interest payments that were due to none other than itself. If, however, a country was negotiating with a whole array of banks, some of which provided the loans and others funded the interest due on those loans, it could be quite some time before the anomaly became apparent. This is indeed what happens because lenders carefully observe such parameters as the D/GDP ratio

230 Lessons from Earlier Accessions

and are not inclined to wait for the ratio to stabilize. They will also analyse the relationship between export revenues and new credit requirements. Hence although it can be assumed that under very special circumstances steady-state growth is possible in the presence of a constant foreign trade deficit, the whole conclusion is in fact worthless because lenders will sooner rather than later refuse to finance such an artificial configuration. Nevertheless it is worth devoting some thought to the problem discussed above when the funds needed to cover the foreign trade deficit are supplied on non-commercial terms. In Germany the new Länder (the provinces that comprised the former GDR) are a case in point; they receive huge federal transfers to finance their trade deficit with the rest of the world, mostly with the old Länder. In 2000 this deficit amounted to about €100 billion and covered about one third of the internal demand, estimated at about €324 billion. Hence the GDP of the new Länder is estimated to be about €224 billion, that is, only about 70 per cent of the internal demand.7 In this way large transfers artificially support a high level of aggregate demand, especially of consumer spending, but at the same time limit production and employment. It is very difficult to tell what the situation would have been in the new Länder if a different policy had been chosen in 1990, especially if they had avoided the politically motivated extreme appreciation of the GDR currency, which scuppered the country’s competitiveness from one day to the next. In any event the difference between internal demand and GDP would have been much smaller and the employment situation probably much better than it is now. The most important point is that future developments would have been much more promising than the cul-de-sac in which the new Länder have found themselves today. To some degree this also applies to the cohesion countries, which are recipients of significant non-commercial transfers from the EU, although in terms of size they are but a very small fraction of those in Germany. No doubt such transfers help to keep domestic absorption above the level of GDP. It is less obvious that the same mechanism keeps GDP and employment below a level that could be achieved if a policy were followed that militated against a constant foreign trade deficit. We stressed this possibility when analysing Figure 8.1. Even if it is financed on non-commercial terms a constant trade balance deficit does not complement domestic savings, as is frequently argued. In reality, if it perpetuates constant import surpluses this kind of financing means lower employment and higher unemployment in the recipient countries. In orthodox theory an import surplus is termed ‘foreign savings’. The term ‘import of unemployment’ from capital-exporting countries to capital-importing countries would be a more adequate description of the real consequences of such a policy. The accession countries harbour great expectations about the increased inflows of FDI they will receive after joining the EU. According to the thinking that prevails in those countries, opening up to international trade and

Kazimierz Laski and Roman Römisch 231

capital flows is the development strategy, not merely part of it. Bearing this attitude in mind, it will be interesting to determine the approximate dynamics of FDI in the cohesion countries before and after their accession. Table 8.2 shows the average annual FDI flows to the cohesion countries in various periods. In Ireland FDI played no relevant role before 1973, nor for many years thereafter. It was only in the 1990s that FDI flooded in. Thus the date of Ireland’s accession had no bearing on FDI inflows, although its membership eventually played a decisive role in attracting them, as will be discussed below. Likewise in Greece, FDI inflows in 1981–85 were less than they had been prior to 1981, but they intensified slightly in the 1990s. Data for Portugal and Spain suggest that for both countries accession was instrumental in attracting FDI. Indeed after 1986, and especially in the 1990s, the flow of FDI to the two countries was much greater than it had been before 1986. However this may have been a coincidence because the accession of the Iberian countries occurred at the same time as an explosion of FDI throughout the world. Annual FDI in developed countries rose from $26.6 billion in the 1970s to $120.9 billion in the 1980s and $317.5 billion in the 1990s. At that time countries could create more or less favourable conditions for FDI inflows, and the example of Greece in the 1990s proves that its conditions were insufficiently attractive. It is evident that countries’ capacity to absorb FDI is limited to some extent by the size of their GDP. A certain number of investment opportunities generally exist in all countries. These are determined first and foremost by the size of their markets, as represented by GDP. Once these opportunities have been seized, further FDI materializes only when these are new openings for profitable investment (new products, new ways of producing old goods) or when the country offers exceptional opportunities for exports. This hypothesis finds some support in data on the relation of FDI stocks to GDP in the cohesion countries (Figure 8.3). Prior to 1998 the FDI stock to GDP ratio in the cohesion countries was about 20–25 per cent. In 1999 Ireland’s ratio soared to 50.7 per cent but these of the other three countries fell to 17–21 per cent. The EU average in the same year was 22.2 per cent. In the transition countries, given the proportion of privatization activities that are in the hands of foreign investors, this percentage will probably be much higher, although sooner or Table 8.2 FDI flows to the cohesion countries, 1970–2000 (yearly averages, million dollars) Ireland Greece Portugal Spain

1970–73: 1976–80: 1970–85: 1970–85:

Source: UNCTAD (2001).

35 481 114 1 003

1981–85: 465

1974–89: 1986–89: 1986–89: 1986–89:

165 703 841 5 868

1990–2000: 1990–2000: 1990–2000: 1990–2000:

4 952 918 2 083 13 117

232 Lessons from Earlier Accessions 70 60

20

50 15

40

10

30

Ireland

Greece, Portugal, Spain

25

20 5

10

0 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Greece

Portugal

Spain

Ireland

Figure 8.3 FDI stocks in relation to GDP, 1980–2000 (per cent)

later it must reach a limit. Thereafter the FDI stock will change in pace with GDP, so the flow of FDI as a percentage of GDP will remain more or less constant.8 Once the FDI stock in a country has reached saturation point the role of current FDI flows as a source of financing the current account shortfall will be very limited as inflows and outflows will be more or less in balance.9 Returning to the cohesion countries, with the exception of Ireland none of them managed to improve their external position after 1980. If they are to avoid future foreign trade bottlenecks in growth acceleration, capital inflows, including FDI, should be used not only to fund the current account import surplus but also to create conditions that are conducive to export expansion and import substitution. Similar use – at least indirectly – should be made of the Structural and Cohesion Funds. The experience of Greece and Portugal suggests that these conditions have yet to be met. Although in 1950–2000 Ireland’s GDP grew at the same rate as those of the other cohesion countries it was the only country to grow more quickly after 1973 than before. However, directly after joining the EU its growth slowed markedly. The strong acceleration of its growth in the 1990s – almost 20 years after its accession to the EU – was mostly due to an upsurge in FDI.10 Ireland is often cited as the best example of a national economy successfully opening up to foreign capital penetration. This is true, but with two caveats: (1) opening up was linked to a branch-type industrial policy and the special interests of US transnational corporations (TNCs); and (2) Ireland’s success, although genuine, has been largely overstated by transfer pricing. Other than linguistic and cultural proximity, the reasons for the concentration of mostly US-dominated FDI in Ireland were the incentives offered to multinational corporations, especially the 10 per cent corporation tax (compared with 30–40 per cent in most competing countries). Tax relief

Kazimierz Laski and Roman Römisch 233

was primarily related to profits from the sale of goods manufactured in Ireland. However the scope of tax relief has since been extended to cover certain well-defined non-manufacturing activities.11 The success of this policy is borne out by the concentration of foreign businesses in the following sectors: ●

● ● ● ● ●

Electronics and information technology, which account for one third of Irish exports. Engineering, especially automotive components and aerospace technology. Pharmaceutical products. Consumer products. International services, including software development. Financial services.

TNCs have focused on export activities in three sectors: computers, chemicals and electrical engineering. According to O’Hearn (2001, p. 83), ‘Ireland’s most important function today is [to be] a site where US companies can shift their products into Europe, while accumulating profits in order to avoid taxation.’ One suspects that Ireland’s success in foreign trade, especially in exports, is partly due to transfer pricing, with the help of which TNCs can shift outside profits to Ireland as a tax haven.12 This hypothesis is supported by the fact that the profits made by foreign firms in Ireland are out of all proportion to FDI stock. Indeed in the 1990s the direct investment income paid in relation to FDI inward stock was in the order of 50–100 per cent. In 1998, out of an FDI inward stock of $20 billion, direct investment income was $22 billion. It should also be stressed that the increase in export surpluses in the 1990s was to a great extent ‘sanitized’ by net factor income from abroad (NFIfA) leaving Ireland. In 1990–98 Ireland’s export surplus increased by about $10 billion while the current account only increased by $1.5 billion. The unusual amount of NFIfA also influenced the relationship between GDP and GNP. Whereas in 1960 Ireland’s GNP was about 9 per cent higher than its GDP, in 2000 it was about 11 per cent lower. Hence over a period of 40 years the ratio of GNP to GDP fell by some 20 percentage points. The question arises of whether the success of FDI-supported Irish growth in the 1990s can be taken as a model for other countries. The answer is probably not. Major US transnational computer, pharmaceutical and electrical engineering corporations that require sites in the EU have already found them, and it is doubtful whether they will need a second site outside Ireland. Tax incentives may work, but only if other countries do not follow suit. No other cohesion country has recorded results that are anything like those of Ireland. Last but not least, it is impossible to find a country outside Europe with the development record of Ireland, with the exception perhaps of such places as Hong Kong and Singapore. We shall now reiterate the most important findings so far with regard to FDI and competitiveness, and the lessons that can be drawn for the

234 Lessons from Earlier Accessions

accession countries. First, the expectation that joining the EU will accelerate the flow of FDI into the accession countries does not seem well founded. This was not the case with earlier rounds of enlargement, and it will probably not happen this time either. It is estimated that about half of the FDI flows to the accession countries over the past few years have been linked to privatization. When all the assets to be privatized have been sold off, this source of FDI will dry up. Second, the argument that relatively low labour costs will attract FDI is not convincing in most cases. It should be recalled that of the four cohesion countries, Ireland had the highest per capita GDP and the highest labour costs. Nevertheless, owing to factors that could not be replicated elsewhere, it succeeded in attracting the highest FDI flows per capita and in relation to GDP. Finally, the share of FDI stock in relation to GDP is already relatively higher in the accession countries than in the cohesion countries, and the former are swiftly approaching what we have called ‘saturation point’ – the level at which FDI flows can no longer be used to fund foreign trade deficits. Even disregarding the outward FDI flows that are already occurring and will continue in the future, when things reach saturation point, net outflows rather than inflows of foreign currency linked to inward FDI can be expected. The second topic is competitiveness, defined here as the ability to cover imports at the required growth rate with adequate exports, or in other words the ability to overcome the foreign trade bottlenecks that endanger growth in any country that is endeavouring to catch up. We have seen that, apart from the atypical case of Ireland, no cohesion country has been able to make progress in this regard, despite the fact that their starting points were much better than those which prevail in the accession countries. Greece, Portugal and Spain recorded lower exports in relation to imports at the end of the investigated period – that is, there was a lower coverage of imports by exports than at the time of their accession. This may have been due to a range of exports failing to penetrate foreign markets or excessive ULCs in relation to the main trading partners. Indeed after joining the EU their ULCs, measured in euros, increased more rapidly than those in the EU-15, thus competitiveness so measured deteriorated rather than improved. This happened despite these countries’ vigorous use of exchange rate policy to offset the excessive growth of nominal ULCs in national currency units. In light of this experience the accession countries should carefully consider the usefulness of a sovereign exchange rate policy. In fact depreciation of the national currency might help to redress these countries’ foreign position by making imports more expensive, accelerating inflation somewhat and lowering real wages (at given nominal wages and labour productivity). Without national currency the only way a country can redress its foreign position is to cut nominal and real wages (at a given labour productivity) in order to lower its ULCs. This should improve its competitiveness, but domestic

Kazimierz Laski and Roman Römisch 235

demand would suffer since the entire burden of the necessary adjustment would have to be borne by wage restrictions.

Convergence of the cohesion countries with the EU average The issue of the cohesion countries catching up with the more developed EU countries can be analysed from two angles. First, did accession to the EU accelerate the growth of the cohesion countries? Second, did accession to the EU accelerate their catching-up process? We shall start with some brief methodological remarks. When comparing two baskets with at least two goods we can obtain a clear-cut answer in two very special cases: when either the material structure of the goods or the price structure of both baskets is identical. The real difficulty arises when – as always happens – both the material and the price structures differ. In this case the size of both baskets and their relationship to each other depend on the common price system chosen for the purpose of comparison. This familiar problem is associated with the Laspeyres and Paasche quantity indices and arises when two different baskets of goods are being compared in the same country over time. When two countries are being compared an additional complication emerges. The two price systems differ not only in structural terms but are also denominated in different currencies. Comparability thus has to be achieved via exchange rates; either those prevailing in reality or others constructed specifically for that end. It should be clear that what we treat as real values when comparing two baskets over time in the same country is not identical to what we treat as real values when comparing two baskets in different countries at the same time. In fact the price systems used in internal and international comparisons are not the same, and therefore the results can and do differ substantially. It can even happen that per capita GDP grows more rapidly in country A than in country B, but the difference between country A and country B in terms of per capita GDP does not increase, remains the same or even diminishes. This means that the results of the two approaches are not transitive.13 In Table 8.3 the years 1973, 1981 and 1986 divide a 40-year period into corresponding subperiods. Growth decelerated after every benchmark year in the EU-11 (that is, the EU-15 minus the four cohesion countries) and the cohesion countries, apart from Ireland.14 It should be stressed that after 1981 growth in Greece was even slower than in the EU-11. In Portugal and Spain (and of course Ireland) the opposite was the case. The difference between per capita GDP growth rates in the EU on the one hand and Ireland, Portugal and Spain on the other, were higher after accession than before: 2.8 per cent versus 0.8 per cent in Ireland, 2.4 per cent versus 1.8 per cent in Portugal and 1.9 per cent versus 1.3 per cent in Spain. Hence the differences were in the range

236 Lessons from Earlier Accessions Table 8.3 GDP per capita, real growth rates, EU-11, cohesion countries, Turkey and United States, 1960–2000 (per cent per annum) 1960–73 1960–81 1960–86 1973–2000 1981–2000 1986–2000 1960–2000 EU-11 Greece Spain Ireland Portugal Ireland GNP Turkey US

2.95 8.15 6.14 3.71 6.98 3.55

2.42 4.84 4.08 3.43 4.76 3.09

2.31 3.73 3.64 3.03 4.08 2.49

1.34 1.23 2.09 4.15 2.39 3.46

1.24 1.22 2.63 4.64 2.88 3.93

1.03 1.64 2.93 5.83 3.45 5.36

1.86 2.91 3.39 4.01 3.86 3.49

2.99 3.08

2.38 2.50

2.45 2.48

2.00 2.09

2.26 2.32

2.08 2.29

2.32 2.41

Source: Ameco database.

of 1.9–2.8 per cent, or if Ireland is disregarded in the range of 1.9–2.4 per cent. In Greece, however, the growth rate after accession was practically the same as in the EU-11, whereas before accession it had been 2.4 per cent higher. For some time systematic intercountry comparisons have been made in terms of purchasing power standards (PPS). Table 8.4 presents some results of these comparisons. If we assume that average per capita GDP in the EU-11 was 100 in the period in question, we can express the relative position of each country as a percentage of that average. It emerges that in both 1960 and 2000 Ireland was the most developed cohesion country. In 1960 the least developed was Portugal (with 36 per cent of the average) and in 2000 it was Greece (with 65 per cent of the average). The change in the relative position of these countries over time applies especially to Ireland and Greece. Ireland lost its lead position as early as 1973, and in 1986 it was still trailing behind Spain. As we already know, Ireland’s GNP differs substantially from its GDP, and in 1986 the country’s relative GNP was still lower than it had been in 1960 and 1973. However in 2000 its per capita GNP was only slightly below the average per capita GDP of the EU-11, while its per capita GDP was well above that level. As far as Greece is concerned, its relative position improved appreciably between 1960 and 1973 (from 40 per cent to 67 per cent of the average) but then deteriorated until 1986. In 2000 Greece’s per capita GDP was not only lower than those of the other cohesion countries, it was also lower than it had been in 1973 (in relation to the EU-11). The above analysis shows that the year of accession of Ireland (1973) and Greece (1981) had no effect on their catching up with the EU-11 average. However when Portugal and Spain joined the EU in 1986 an effect did materialize and partly compensated for the losses of the preceding years. Figure 8.4 provides some additional details to those in Table 8.4 because it covers not only the benchmark years but also the whole 40-year period. The direction of changes reported in Figure 8.4 is not uniform. Ireland’s catching-up process

Kazimierz Laski and Roman Römisch 237 Table 8.4 GDP per capita, in PPS terms, cohesion countries, Turkey and United States, 1960–2000 (EU-11 ⫽ 100)

EU-11 Greece Spain Ireland Portugal Ireland GNP Turkey US

1960

1973

1981

1986

2000

100.0 40.2 54.1 57.5 36.5 60.7 29.6 148.3

100.0 67.2 72.9 56.7 54.8 60.6 27.1 136.8

100.0 64.1 67.5 62.8 52.4 63.4 26.2 134.2

100.0 58.5 66.9 60.8 50.7 57.8 27.3 137.1

100.0 64.6 78.9 110.0 72.8 97.9 27.0 148.2

120 110 100 90 80 70 60 50 40 30 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 Greece

Spain

Ireland

Portugal

Figure 8.4 Per capita GDP at PPS (EU-11 ⫽ 100)

only started in the late 1980s, while Portugal stagnated between the early 1970s and late 1980s. As already mentioned, for most of the 1970s Greece’s relative position was higher than it became in the late 1990s, while Spain’s relative position in the late 1990s was only slightly better than it had been in the mid 1970s. We have separately analysed data in constant prices, showing changes over time, and in PPS, showing changes in the relative positions of the EU-11 and the four cohesion countries. It is possible to combine both approaches by using constant PPS. By starting with data from a certain year we can obtain the ranking of countries’ real growth rates over time. One should stress, however, that the choice of year influences the results of the exercise. Maddison (2001) has produced this kind of data using 1990 international Geary–Khamis (G–K) dollars for almost all countries in a millennial perspective,

238 Lessons from Earlier Accessions

while Ellison (2001) has used them to analyse the long-term convergence of regions in Europe. In that context Ellison introduced the concept of the cohesion countries as a region and we have adopted this concept in order to analyse their catching-up process. The results for the period 1950–2002 (divided into subperiods according to the countries’ accession years – 1973, 1981 and 1986) are presented in Table 8.5 and Figure 8.5. Although our focus is on the cohesion countries and the EU, we have introduced data for other regions as a useful background for our analysis. According to Table 8.5, per capita GDP in the cohesion countries in 1950 was only 47 per cent of the EU-10 average, but by 1973 it had risen to 68 per cent. In 1973–86 their relative position deteriorated by 5 per cent, equalling 64 per cent of the EU-10 average, but in 1986–2002 the catching-up process recommenced and their relative position improved by over 10 percentage points. In sum, since 1973 – that is, over a period of almost 30 years – the position of the cohesion countries in relation to the EU-10 had improved by a mere 9 percentage points, reaching 77 per cent of the EU-10 average in 2002. The data on the individual countries are also interesting. During 1950–86 (that is, over a period of 36 years) Ireland’s position deteriorated by over 9 percentage points, only to rise in the 16 years thereafter by Table 8.5 Per capita GDP, 1950–2002 (in constant 1990 international Geary–Khamis dollars, EU-10 ⫽ 100)

Austria Belgium Denmark Finland France Germany Italy Netherlands Sweden United Kingdom Ireland Greece Portugal Spain Cohesion countries Turkey United States Asian Tigers1

1950

1973

1981

1986

2002

75.2 110.8 140.9 86.2 106.9 78.7 71.0 121.6 136.6 140.1

93.3 101.1 115.8 92.1 109.0 99.4 88.4 108.7 112.1 99.9

98.5 102.6 108.4 94.3 109.0 101.6 94.8 104.3 107.2 91.6

98.2 98.9 117.4 96.7 105.5 101.0 94.7 101.9 107.9 96.1

101.7 105.2 118.2 102.1 105.7 94.3 95.0 108.3 103.6 101.2

69.9 38.8 42.0 48.6 47.2

57.0 63.6 61.0 72.6 68.5

62.6 63.9 58.3 67.7 65.3

60.4 61.5 55.8 66.5 63.6

118.4 63.0 70.6 78.8 77.3

36.9 193.9 19.4

31.2 138.6 30.2

29.9 135.5 40.4

31.4 138.6 51.4

30.2 148.3 79.22

Notes 1. Hong Kong, Singapore, South Korea, Taiwan. 2. Up to 1999. Source: Maddison (2001), own calculations.

Kazimierz Laski and Roman Römisch 239 35 000 30 000 25 000 20 000 15 000 10 000 5000 0 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 EU-10 US

Turkey Asian Tigers

Cohesion countries

Figure 8.5 Per capita GDP, 1950–2002 (in constant 1990 international G–K dollars) Source: Madison (2001).

almost 60 percentage points (at least in GDP terms; in GNP terms the improvement was less dramatic). Greece did not improve its position after accession, but it was the most successful country before accession. The Iberian countries improved their position by 14–18 percentage points before accession and 12–14 percentage points after accession. An efficient catching-up process can be observed for Italy, and in particular for Austria. During 1950–2002 the latter country grew by an average of 4.9 per cent before 1973 and 2.1 per cent after 1973. In 1950 its per capita GDP stood at 75.2 per cent of the EU average but by 1995, the year in which Austria joined the EU, had risen to 101.2 per cent. Thus Austria’s catchingup process was complete before its accession to the EU. A much more spectacular example of catching up was that of the ‘Asian Tigers’. In 1950 their per capita GDP amounted to only 19 per cent of the EU-10 average. However over the period in question their average annual growth rate was 5.8 per cent, 3 per cent more than in the EU-10, and by 2002 their per capita GDP stood at 79 per cent of the EU-10 average (an improvement of 60 percentage points), slightly above the level reached by the cohesion countries. Figure 8.5 shows the absolute levels of per capita GDP over time and helps us to understand the difference between catching up in percentage and volume terms. Per capita GDP growth measured in per cent is one side of the story, the basis for the percentage calculation is the other. The greater the initial difference in the level of GDP the greater the difference in growth

240 Lessons from Earlier Accessions

rates has to be in order to reduce the difference between the target and catching-up countries in volume terms. Indeed successful catching up in terms of percentage of the target GDP does not necessarily mean that absolute differences between countries diminish.15 This problem is illustrated in Figure 8.6, in which each point measures the difference between the per capita GDP of the countries and groups of countries shown and that of the EU-10 during 1950–2002. As we already know, per capita GDP in the cohesion countries increased in relation to that in the EU-10 – from 47 per cent in 1950 to 77 per cent in 2002. However the absolute difference between the two groups increased from $2605 in 1950 to $5482 in 1989 and dropped to $4545 in 2002. Similarly the difference in volume terms between the Asian Tigers and the EU-10, which in 1950 amounted to $3973, continued to increase until about 1980. Thereafter it decreased, reaching $4511 in 1998. The findings so far in this section seem to be rather important for the accession countries. First, in percentage terms it took the cohesion countries half a century to move from 47 per cent to 77 per cent of the per capita GDP of the EU-10. During the same period the difference between them in volume terms almost doubled. Second, a substantial part of catching up in percentage terms took place before 1973, a period in which Europe as a whole reported unprecedented growth rates. Third, during that period all the cohesion countries vigorously pursued an industrial policy of the old type, in which protection levels for the domestic economy were high and capital markets were strictly regulated. This also applied to Austria and especially to the Asian Tigers, which were exceptionally successful in catching up with the EU-10. 10 000 5000 0 –5000 –10 000 –15 000 –20 000 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 EU-10 US

Turkey Asian Tigers

Cohesion countries

Figure 8.6 Difference between per capita GDP in selected countries and that in the EU-10, 1950–2002 (in constant 1990 international G–K dollars)

Kazimierz Laski and Roman Römisch 241

Data for the accession countries are presented in Table 8.6. In 2002 the average per capita GDP in these countries was €10 839 compared with €23 337 in the EU-15; thus per capita GDP in the accession countries amounted to 46.4 per cent of the EU-15 level in that year. These percentages conceal major differences among the accession countries, for example per capita GDP in the Czech Republic was almost 50 per cent higher than in Poland. The growth rates for the period 1989–2002 are presented in Table 8.7. In 1989–2002 per capita GDP increased more slowly in the accession countries than in EU-15, however in the subperiod 1995–2002 it was by 1.5 percentage points faster. Let us assume that in the future the EU-15 will grow at 2 per cent per annum, a little more quickly than in 1989–2002. Assuming that the accession countries enjoy a future growth rate of 3–5 per cent per annum, we can determine the number of years they will need to reach 75 per cent and 100 per cent of the EU-15 average (Table 8.8). It seems that the catching-up process will be at least as difficult for the accession countries as it was for the cohesion countries. Indeed they will not have the benefits enjoyed by the latter in the period 1950–73, when growth rates in Europe were extremely high and pronounced intervenionist economic policies prevailed. Even if they were willing to pursue such policies (which would not be the case by any means), once inside the EU measures of that kind would be prohibited under the competition policy rules and regulations that are monitored by Brussels. A second factor is the foreign trade bottlenecks that currently exist Table 8.6 Per capita GDP in the accession countries, according to WIIW estimates 2002 (in PPS)

In Euros Percentage of EU-15

Czech Republic

Slovakia

Hungary

Poland

Slovenia

AC-5

14 639 61

12 347 51

12 563 52

9 754 41

17 074 71

11 362 47

Source: WIIW estimates.

Table 8.7 Growth of per capita GDP in the accession countries and EU-15, 1989–2002 (per cent per annum)

EU-15 Czech Republic Hungary Poland Slovakia Slovenia Accession countries Source: WIIW database.

1989–95

1995–2002

1989–2002

1.3 ⫺1.0 ⫺2.5 ⫺0.5 ⫺3.1 ⫺1.2 ⫺1.2

2.0 1.9 4.1 4.0 3.7 3.9 3.5

1.7 0.6 1.0 1.9 0.5 1.5 1.3

242 Lessons from Earlier Accessions Table 8.8 Number of years needed by the accession countries to reach 75 per cent and 100 per cent of the EU-15’s per capita GDP1

(per cent) 75 100

Growth at 3% p.a. (years)

Growth at 4% p.a. (years)

Growth at 5% p.a. (years)

50 80

27 42

19 29

Note 1. Assuming a 2 per cent per annum growth rate for the latter and a stagnant population in all countries.

in all the accession countries, although their growth rates are modest when viewed in terms of the requirements for the catching-up process. It is quite probable that any acceleration of growth will quickly have a negative impact on the trade and current account balances, thus calling for restrictive measures to keep the deficits within tolerable limits. Under these conditions it will not be easy to obtain even a 3 per cent growth of per capita GDP. Since it can be expected that growth rates will be lower in some years than in others, an average of 3 per cent implies there will be years in which the growth rates will have to exceed that level. It should be noted that in 1973–2002 the cohesion countries only achieved an average per capita GDP growth rate of 2.1 per cent. On the other hand the EU-15’s future growth rate of 2 per cent may well be an overestimate, especially if their record after 1989 is taken into account. Perhaps 1.5 per cent is a more realistic forecast for the coming decennia. If we assume that per capita GDP in the EU-15 and the accession countries will grow by 1.5 per cent and 3.5 per cent per annum respectively, it will take the latter countries nearly half a century to reach 75 per cent of the EU-15 average. Of course taking into account the current differences among the accession countries Slovenia and the Czech Republic, for example, will reach the 75 per cent level much more quickly than Poland. There is no doubt that membership of the EU will stabilize democracy in the accession countries, thus strengthening the political situation in Europe. However it is doubtful that membership will accelerate their growth and significantly aid their catching-up process.16 Indeed the strategy chosen by the accession countries in the early 1990s to modernize their economies was unique. Without exception today’s developed countries went through a phase of industrialization in which they protected their infant industries, and only after an appropriate period of time did they open up their markets to foreign competition. The situation at the beginning of transition in the

Kazimierz Laski and Roman Römisch 243

early 1990s was quite different and the message that most developed countries conveyed to the transition countries was more along the lines of ‘Don’t do what we did, do what we say’! Rodrik (2001, pp. 100–1) describes this contradiction in very precise terms: No country has developed successfully by turning its back on international trade and long-term capital-flows.… But it is equally true that no country has developed simply by opening to foreign trade and investment. The trick in the successful cases has been to combine the opportunities offered by world markets with a domestic investment and institution building strategy to stimulate the animal spirits of domestic entrepreneurs … almost all the outstanding cases have involved partial and gradual opening to imports and foreign investment. Multilateral institutions such as the World Bank, International Monetary Fund, and Organisation for Economic Co-operation and Development regularly give advice predicated on the belief that openness generates predictable and positive consequences for growth. Yet there is simply no credible evidence that across-the-board trade liberalization is systematically associated with higher growth rates. Notes 1. This chapter is based on the report ‘From accession to cohesion: Ireland, Greece, Portugal and Spain and lessons for the next accession’, study commissioned by Bank Austria Creditanstalt, preliminary version, WIIW, Vienna, December 2002. The authors are grateful for critical comments by colleagues at WIIW, Hubert Gabrisch (IWH Halle) and Julio Lopez (University of Mexico City). 2. See for example Baldwin et al. (1997). 3. This can be interpreted as the entire additional investment being imported from abroad without any domestic input. 4. See Podkaminer (2000). 5. See Kowalewski and Reitschuler (2003). 6. Ibid. 7. These estimates have been supplied by Dr Hubert Gabrisch at the Institute for Economic Research, Halle, Germany, whom we thank for his help. 8. For example if the constant ratio of FDI stock to GDP amounts to a per cent and the growth rate of GDP to b per cent, the FDI inflow will be (ab)/100 per cent. If a ⫽ 50 per cent and b ⫽ 4 per cent the FDI inflow will be equal to 2 per cent of GDP. 9. In the previous note we put FDI at 2 per cent of GDP in order to keep the existing FDI stock to GDP ratio constant at 50 per cent. If the ratio of profits to FDI stocks were 5 per cent, foreign profits in relation to GDP would amount to 0.05(0.5) ⫽ 0.025, that is, to 2.5 per cent. Assume now that only one fifth of total foreign profits (that is, 0.5 per cent of GDP) is distributed and the rest is invested in the country. As long as steady-state growth with these parameters prevails, the net outflows related to FDI will amount to 0.5 per cent of GDP.

244 Lessons from Earlier Accessions 10. In 1974–89 the average annual flows of FDI to Ireland amounted to $165 million and in 1990–2000 to $4952 million, that is, they increased by a factor of 30. In the same period FDI in the remaining cohesion countries increased by a factor of slightly above 2. 11. These activities include international financial services, carried out at the International Financial Services Centre in Dublin; certain computer services (software development, data processing and related technical and consultancy services), which have been grant aided; wholesale sales by special trading houses of goods manufactured in Ireland; design and planning services for specific engineering works executed outside the EU (services provided by engineers, architects and quantity surveyors); the repair or remanufacture of own-manufactured computer equipment; the repair of ships, aircraft and aircraft engines and components; certain shipping activities; film production (movies); and fish farming, meat processing and the micropropagation and cloning of plants. 12. The hypothesis on the shift of profits to Ireland as a tax haven is supported by an analysis of unit value prices (ECUs per ton) in Irish foreign trade by Robert Stehrer (WIIW) who found that in intra-EU trade in 1989–1990 the average unit value prices (UVPs) of Irish exports were twice as high as those of the EU and the UK, whereas in 1997–98 they were 3.5–4 times higher. On the other hand in 1989–90 the average UVPs of Irish imports were equal to those of the EU and about half of those of the UK. During the 1990s these ratios did not change very much. The results for extra-EU trade in the same periods were similar, but were less to Ireland’s advantage. These figures indicate that high export prices were used as a vehicle to shift profits to Ireland, especially from the EU. 13. From Table 8.3 it follows that in 1960–2000 Turkey experienced higher per capita GDP growth than the EU-11 (2.3 per cent as against 1.9 per cent); however from Table 8.4 we learn that the relative position of Turkey in relation to the EU-11 deteriorated instead of improving. 14. However in per capita GNP terms, even in Ireland the growth rate after 1973 was slightly lower than that before. 15. For the distinction between ␤ and ␴ convergence see Barro and Sala-I-Martin (1995), p. 382 ff. 16. Ellison (2001, p. 46) goes even further in his analysis: ‘government officials and others in the CEEC’s frequently point out that they have no choice but to join the European Union in order to become more economically competitive and politically stable. Ironically, this one argument may in fact be one of the strongest points for remaining outside. Many countries have successfully promoted economic growth and convergence while remaining outside the EU. Ultimately, this may constitute a more viable alternative.’

References Baldwin, R. E., J. F. François and R. Portes (1997) ‘The costs and benefits of eastern enlargement’, Economic Policy, vol. 24 (April), pp. 125–76. Barro, R. J. and X. Sala-I-Martin (1995) Economic Growth (New York: McGraw-Hill). Boltho, Andrea (2000) ‘What matters for economic success. Greece and Ireland compared’, in Zoltan Bara and Laszlo Csaba (eds), Small Economies’ Adjustment to Global Tendencies (Budapest: Aula), pp. 151–69. Breuss, Fritz (2001) ‘Macroeconomic Effects of EU Enlargement for Old and New Members’, WIFO Working Papers no. 33 (Vienna: WIFO, June).

Kazimierz Laski and Roman Römisch 245 Bryant, Ralf C., Nicholas C. Garganas and George S. Tavlas (eds) (2001) Greece’s Economic Performance and Prospects (Athens and Washington, DC: Bank of Greece and the Brookings Institution). Detragiache, Enrica and Alfonso J. Hamann (1997) ‘Exchange-Rate-Based Stabilization in Western Europe: Greece, Ireland, Italy and Portugal’, IMF Working Paper WP/97/75 (Washington, DC: IMF, June). Ellison, David L. (2001) ‘CEEC Prospects for Convergence: A Theoretical and Historical Overview’, in Michael Dauderstädt and Lothar Witte (eds), Cohesive Growth in the Enlarging Euroland (Bonn: Friedrich-Ebert-Stiftung, International Policy Analysis Unit). Georgakopoulos, T. N. (2001) ‘Cohesive Growth in the Enlarging Euroland: Patterns, Problems and Policies – Case Study Greece’, paper presented at the conference on ‘Cohesive Growth in the Enlarging Euroland: Patterns, Problems and Policies’, Friedrich-Ebert-Stiftung/Franziska- and Otto-Bennemann-Stiftung, Berlin, 7–9 June. Hunya, G. (2001) ‘Auswirkungen der ausländischen Direktinvestitionen auf Wachstum und Umstrukturierung in Mittel und Osteuropa’, in Bundesministerium für Wirtschaft und Arbeit, Österreichs Aussenwirtschaft 2001/02 (Vienna: Bundesministerium für Wirtschaft und Arbeit), pp. 233–53. Hunya, G. (2002) ‘Recent Impacts of Foreign Direct Investment on Growth and Restructuring in Central European Transition Countries’, WIIW Research Report no. 284 (Vienna: WIFO, May). Kalecki, Michal (1993) Collected Works, vol. IV, edited by Jerzy Osiatynski (Oxford: Clarendon Press). Kowalewski, Pawel and Gerhard Reitschuler (2003) ‘Experience stemming from the ERM for the Accession Economies willing to join the ERM’ (Vienna: OeNB), forthcoming. Maddison, Angus (2001) The World Economy. A Millennial Perspective (Paris: OECD). Neves, J. (1996) ‘Portuguese postwar growth: a global approach’, in Nicholas Crafts and Gianni Toniolo (eds), Economic Growth in Europe since 1945 (Cambridge: Centre for Economic Policy Research and Cambridge University Press). O’Hearn, Denis (2001) ‘Economic Growth and Social Cohesion in Ireland’, paper presented at the conference on ‘Cohesive Growth in the Enlarging Euroland: Patterns, Problems and Policies’, Friedrich-Ebert-Stiftung/Franziska- and Otto-BennemannStiftung Berlin, 7–9 June. Pelkmans, J., D. Gros and J. Nunez Ferrer (2000) ‘Long-Run Economic Aspects of the European Union’s Eastern Enlargement’, WWR Working Document W 109 (The Hague: WWR Scientific Council for Government Policy), pp. 107–28. Podkaminer, Leon (2000) ‘Sustainability of Poland’s “import-fed” growth’, The Vienna Institute Monthly Report, vol. 4 (April), pp. 2–8. Rodrik, Dani (2001) ‘Development Strategies for the 21st Century’, in Boris Pleskovic and Nicholas Stern (eds), Annual World Bank Conference on Development Economics (Washington, DC: World Bank). Sanso, M. and A. Montanes (2000) ‘Cointegration, Error Correction Mechanism and Trade Liberalization: The Case of Spanish Imports of Manufactures’, Applied Economics, vol. 34, pp. 231–40. Schreyer, Paul and Francette Koechlin (2002) Purchasing Power Parities: 1999 Benchmark Results (Paris: OECD). United Nations Conference on Trade and Development (2001) World Investment Report (Geneva: UNCTAD).

9 Moving the Escudo into the Euro1 Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas

Introduction It took ten years and two Prime Ministers (right then left) to make Portugal a founding member of the eurozone. The efforts of successive duos of five ministers of finance and three central bank governors were required and the euro conversion rate was set at 200 escudos, some 16 per cent lower than the rate at which the escudo entered the ECU basket in 1989. Moreover the implementation of a stability-oriented macroeconomic policy was completed at a time when the parity grid of the Exchange Rate Mechanism (ERM) of the European Monetary System was under severe strain. The understanding shown by the Portuguese authorities for the ERM code of conduct as they prepared to join after the general election in 1991 made it possible for Portugal to acquire a sound financial reputation very quickly. Enhanced national credibility abroad, however, was accompanied by tension between some minister/governor duos, especially on the timing of ERM entry, the speed at which to move to full currency convertibility, whether the escudo should respond to peseta realignments as well as supervision issues. Moreover both the opposition and the governing party initially resisted the stability-oriented policy, stalling structural reforms and enabling the opposition to win the 1995 general election on a reformist platform. As a consequence the stability-oriented policy was maintained until the country qualified for economic and monetary union, but there were no other major reforms. This chapter documents how the code of conduct inherent in participation in the ERM allowed Portugal to qualify for economic and monetary union (EMU), ultimately moving the escudo into the euro. This unwritten code of conduct reflects the conditions under which the ERM can be seen as an instrument of convergence. In 1992–93 Portugal’s credibility abroad was enhanced by its adherence to the ERM multilateral surveillance procedures through successive convergence programmes. At that time the ‘stability culture’ was unknown to the two major political parties and was therefore likely 246

Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas 247

to be questioned by whichever party was in opposition. As preference for stability became evident at home and abroad, the benefits of policy credibility became more apparent in economic activity and employment. Yet until a broad monetary union became fully credible, there was fear that the escudo would suffer from contagion by the peseta and would thus fail to qualify. Contagion reflects imperfect market information about peripheral economies with a poor financial reputation, and is especially grave in times of turbulence or crisis. In the end, the rule-based ERM regime proved stronger than these so-called ‘geographic fundamentals’. The remainder of this chapter consists of two sections. The next section describes Portugal’s successive exchange rate regimes and explains how the move towards stability and convertibility, which only became possible in 1989, began gradually and was almost reversed in 1990 and 1991. Gradualism reflected the fact that, until 1995, the Prime Minister balanced two conflicting objectives: gaining credibility abroad and selling stability at home. The stochastic properties of the weekly escudo/Deutschmark rate since the last realignment of the French and Belgian francs in January 1987 were consistent with this gradual change, which includes five subperiods before volatility subsided in late 1997. The turning points were the beginning of stage one of EMU in July 1990, ERM entry in April 1992, the widening of the ERM bands in August 1993 and the final realignment of the peseta and the escudo in March 1995. Although, not being market-determined, a non-convertible currency would have tended to be less volatile than a convertible currency, Table 9.4 in the appendix to this chapter shows that under a crawling peg and Deutschmark shadowing, conditional volatility was greater than in the period after the widening of the bands and the final realignment (labelled as ‘peseta’). The comparison excludes both the crisis regime and the last subperiod. The subsequent section takes a closer look at the third subperiod: the first year of Portugal’s ERM membership. This coincided with attacks on the parity grid, which ultimately led to the widening of the fluctuation bands to 15 per cent. An attempt is made to distinguish between domestic disturbances and the consequences of system instability on the behaviour of the weekly escudo/Deutschmark rate. The result suggests that, had it been delayed beyond April 1992, in all likelihood the member states would not have been able to agree upon Portugal’s entry until after the last peseta realignment three years later, and by then, the general election would have been too close to allow such a decisive step to be taken. Stressing the unfinished research agenda on the stochastic properties of the escudo/Deutschmark exchange rate, the conclusion and the appendix to this chapter consider the changes in conditional volatility and the impact of central bank intervention. The absence of structural reforms to lock in the benefits of EMU is seen as an example of ‘euro hold-up’ that could ultimately rekindle the conflict between earning credibility abroad and selling stability at home. This is indeed what happened after euro membership was secured.

248 Moving the Escudo into the Euro

Successive exchange rate regimes The gradual shift in Portugal’s economic regime towards price stability and currency convertibility was marked by several exchange rate regimes prior to ERM membership. Not all of them facilitated a change in regime, and one almost reversed it. After membership had been secured, however, the system became unstable and the final realignment took place in 1995. The following paragraphs describe the exchange rate regimes that prevailed until economic and monetary union became fully credible, except for the crisis regime, which is analysed separately in the conclusion to this chapter. In September 1989 the escudo entered the ECU basket at a rate of 172.2 With the benefit of hindsight, this marked the onset of change in the economic regime that would ultimately move the escudo into the euro. Two types of reforms defined the change. Some, such as the constitutional amendment that reversed the 1976 freeze on privatization, were public but their relation to financial liberalization was not immediate. Others, such as the multi-annual fiscal adjustment strategy (MAFAS) presented to the European Commission, were relevant but not public.3 Despite these reforms, neither the government nor the social partners saw ERM membership as imminent. The cabinet was reshuffled shortly after the local elections in 1989, further delaying public awareness of the ongoing regime change. A Foreign Exchange Law, in which criminal charges were replaced by fines, was approved in autumn 1989 and was heralded as a major reform by Finance Minister Miguel Cadilhe. On being promulgated in early 1990, however, it allowed Miguel Beleza, Cadilhe’s successor, to keep the administration of exchange controls with the central bank, from whose board he had come to the ministry. In fact until after the general election of 1991 the central bank, headed by Tavares Moreira since 1986, almost completely determined macroeconomic policy. The crawling peg policy, which had been introduced in 1977 on the advice of the International Monetary Fund (IMF), was replaced in the spring of 1990 by a shadowing of the Deutschmark – this was known, but not officially acknowledged, as a ‘hard escudo’ policy. Since the change was not announced publicly it cannot be interpreted as a prepegging exchange rate regime (PPERR) to complement the MAFAS. A very low level of unemployment, however, coupled with strong upward pressure on public sector wages led to strong inflationary pressures and an appreciation of the real exchange rate. Moreover fear that financial freedom would threaten monetary control and undermine the soundness of the banking system was heavily ingrained in the central bank, which was responsible for administering exchange controls. Decree law 13/90 of 8 January 1990 allowed the central bank to reinstate exchange controls and this remained the case with Decree law 176/91 of 14 May 1991, despite the principle of freedom stated in Article 3. The Foreign Exchange Law gave the central bank the right to issue avisos (signed by the minister of finance), whereby exchange controls could

Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas 249

be introduced or relaxed. On 21 May 1991 the first aviso was used to introduce an interest-free deposit of 40 per cent for loans contracted abroad (except when the operation related to financing current transactions) and to prohibit forward purchases of escudos between resident and non-resident banks (forward sales were still not permitted). The controls were reinforced before the general election (aviso 7 of 5 July 1991) with explicit reference to the threat that excessive capital inflows posed to monetary and exchange rate policy. Stricter controls were supposed to help prevent inflation from accelerating and the cost of servicing the public debt from increasing. The central bank’s foreign reserves more than doubled over the period 1989–91, with disastrous consequences for the bank’s operating results. The opaque arrangement managed by the central bank also allowed banks to delay adjusting to a single market in financial services. In short the bank was accumulating huge dollar deposits that earned 5 per cent while paying 20 per cent on the escudo debt being issued to mop up the resultant ‘excess’ liquidity and shadowing the Deutschmark in the fight against inflation.4 In July 1990 Beleza proposed a ‘National Adjustment Framework for the Transition to Economic and Monetary Union’, known as QUANTUM, but it was not until after the elections in 1991 that Braga de Macedo, Beleza’s successor, presented a convergence programme that combined MAFAS and PPERR with capital account liberalization. When he discussed the programme in parliament he called it Q2 to stress the continuity of the gradual change in regime. Despite Q2, the decision to request the entry of the escudo into the ERM came as a genuine surprise. On 4 April 1992 – during the weekend following parliamentary approval of the 1992 budget – the monetary committee (whose members were acting in their capacity as personal representatives of the 12 minister/governor duos who met with the European Commission in the so-called informal ECOFIN) responded to the government’s application to join the ERM at a rate of 180 escudos.5 Even though a precedent had been set with sterling, the prior declaration of a parity met with great resistance among some members of the monetary committee. Fearing that, on the eve of the British general election, a weaker escudo might infect the pound sterling, consensus was reached on a notional central rate of 178.7 – the rate that had prevailed since the entry of sterling in October 1990. The social partners were briefed on Friday afternoon after a special cabinet meeting. The following week the government called for a parliamentary debate.6 Nevertheless the rule-based exchange rate regime, which culminated in a gradual change in the economic regime, was neglected at home. This remained true even when both the outcome of the Danish referendum and the severe recession made it clear that the escudo would be unable to join the ERM in time to meet the economic and monetary union criterion of two years’ membership. Together with the Greek drachma, it would have trailed behind and outside the parity grid, rather than tracking the peseta inside.

250 Moving the Escudo into the Euro

Domestic neglect of ERM membership may have been due to the fear of ‘geographic fundamentals’ involving Spain. One of the major consequences of this fear was the general expectation that, based on evidence from the previous ten years, employment performance would be unfavourable. As a consequence of the severe structural adjustment agreed to with the IMF in 1983–85, Portugal’s recorded rate of unemployment had been about one third that in neighbouring Spain. Even the perceived link of the escudo with the peseta does not fully explain why the international financial markets trusted the change in regime almost five years before the trade unions, employers’ associations and citizens. Alternatively, the fact that the domestic stability culture paradoxically recovered at a time of systemic instability possibly explains the domestic neglect. The experience of the period before 1974, when the central bank had had private shareholders and the currency had been stable, if not fully convertible, was either forgotten or associated with the absence of political freedom (or both). The available indicators still show a much larger current account openness than capital account openness, and only now is there growing appreciation of the implications that moving the escudo into the euro has for firms, regions and cities. In any event the central rate the escudo kept after the realignment of the peseta in March 1995 (around 196) would have been difficult to attain without the benefit of the ERM code of conduct, as suggested in the conclusion below. The MAFAS retained in the revised convergence programme (the PCR), which had been approved together with the 1994 budget, kept the nominal ceiling on non-interest expenditures that had been set in Q2, but adjusted the deficit for revenue shortfall. This was readily accepted by international investors, who heavily oversubscribed to a global bond issue of $1 billion in September 1993, as well as by the monetary committee, which approved the PCR in November. A cabinet reshuffle involving the Finance Ministry and three spending ministries was announced shortly before the local elections in December, but Eduardo Catroga, Macedo’s successor, kept economic policy consistent with the PCR. In early 1994 a global bond issue in ECUs met with the same success as the previous one. Yet Catroga’s call for lower interest rates, while directed at a domestic business audience, had foreign repercussions, especially when the call was thought to have the prime minister’s approval. In this context an Austrian news agency reported rumours of a military coup in Portugal. While entirely groundless, the story led to a renewed attack on the escudo. Differences of opinion about banking supervision between Catroga and Beleza, who had succeeded Moreira in May 1992, led to most of the board being replaced and Antonio de Sousa being appointed as governor in June 1994. This drastic move was widely accepted as it was clear that the tension did not have its origins in monetary policy. Since then further changes have been introduced to the statutes of the central bank, making it more independent of the government, introducing some accountability in parliament and improving the regulation and supervision

Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas 251

procedures. Just as the ERM code of conduct had helped to move the escudo into the euro, the European Union Treaty and the Banking Law introducing the single market in financial services, both of which became effective in 1993, forced the central bank to adjust to currency convertibility. Another reflection of the continuity of the MAFAS beyond the 1995 general elections is that the PCR proposed in 1993 extended the expenditure ceilings into 1997 and remained the basis for the excessive deficit procedures until a convergence, stability and growth programme covering the period 1998–2000 was approved in May 1997 by ECOFIN, where it was presented by the minister of finance, Sousa Franco. Franco announced a stability and growth programme for 1999–2001 shortly after the escudo joined the euro.7 Nonetheless the public administration remained incapable of reforming itself in areas such as justice, home affairs, social welfare and education, and therefore the opportunity for sustained structural change afforded by the euro and the associated improvement in fiscal discipline was lost. The absence of structural reforms was especially grave as far as the enlarged public sector and the discretionary regulation of private enterprise were concerned. That is why the rule-based exchange rate regime, coupled with a credible MAFAS, was such a decisive indicator of the change in economic regime. As it turned out, the 1993 recession and the (general and local) election cycles hindered the reform of the public sector, including social security. Braga de Macedo (2001) calls this the ‘euro hold-up’. Cabinet reshuffles involving the minister of finance and major spending ministers took place around the time of local elections. As they occurred in the middle of the parliamentary term, they played an uncanny role in the regime change and its reversals.8 The implementation of the MAFAS and PPERR between 1989 and 1992 was closely associated with the prime minister, but different voices were needed to stress international and domestic objectives on an alternating basis. The four successive finance ministers serving until 1995 either implemented structural reforms with a high degree of external visibility or were required to hold the line domestically, rather than pressing for reforms that hurt vested interests. A rather extreme example was the Banking Law of 31 December 1992, which introduced free market principles in financial services and called for greater supervision and competition. Several drafts had been discussed by the Treasury and the central bank ever since the Cadilhe/Moreira duo, but operating procedures did not begin to change until the Catroga/Sousa duo assumed office, meaning that six minister/governor duos had been involved.9 The cabinet was also reshuffled at the time of the local elections in 1997, when EMU was becoming feasible for many member states. Yet Franco did not have to resign so that the new prime minister could sell stability at home. The pattern of alternating between international and domestic objectives in macroeconomic policy making can thus be associated with the task of moving the escudo into the euro. That notwithstanding, failure to carry out structural reforms – or even to make a credible announcement

252 Moving the Escudo into the Euro

of such reforms – jeopardizes the accrual to people and businesses alike of the benefits of a stable and convertible currency. As it turned out, the December 2000 local elections led to the resignation of the left Prime Minister whose party was defeated in the 2001 general elections.

The ERM crisis: a closer look Paradoxically the return to the stability culture in Portugal occurred at a time of systemic instability. This paradox may explain the domestic neglect of ERM membership. It seems, however, that without the benefit of the ERM code of conduct it would have been difficult to maintain the central rate that the escudo had kept after the realignment of the peseta in March 1995. This section provides evidence to this effect by examining some episodes of domestic controversy that occurred at the same time as the ERM crisis and thus provided early tests for the credibility of Portugal’s policy, from which the convertible escudo emerged victorious (Tables 9.1 and 9.2). The central bank found it extremely difficult to restore full convertibility on 16 December 1992 because the board had only reluctantly agreed to a renewal of controls for increasingly shorter periods. Their elimination had not been announced until the summer of 1992, and then only after a threat of legislative action to withdraw the central bank’s power to issue avisos. The virtual hold on policy making that Moreira’s board enjoyed in 1990–91 made it even more difficult for Beleza to accept that restoration of full currency convertibility could be achieved prior to the expiry in 1995 of derogation to the fourth Brussels directive, which had been negotiated by Greece and Portugal, instead of seeking its extension until 1993 or 1994 (by which time Greece would have completed its liberalization). Macedo introduced several procedures that could have helped establish a two-way dialogue between the Treasury and the central bank.10 On 3 March 1993 he publicly urged the central bank to adjust to a period of full currency convertibility and heed the accumulating evidence that recession was hitting the domestic economy. Although raised in the sessions with the bank’s board, two implications of convertibility were not made explicit in his plea: allowing greater banking competition and lowering money market rates, even if this meant letting the escudo slide towards the middle of the 6 per cent ERM band rather than being glued to the top. Better banking supervision would lead to a decline in the cost of credit without the need to change the stance on monetary policy. Flexibility at the top end of the band would reflect the benefit of the ERM code of conduct relative to opaque Deutschmark shadowing. Some days later a vice governor who, since being appointed in 1990, had been the most outspoken advocate of the hard escudo policy resigned and Reuters aired a rumour that Beleza would follow suit. While this rumour proved unfounded the adjustment to convertibility was depicted as a crisis rather than a natural move towards a better financial reputation. Hence the

Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas 253

socialist opposition, which had openly questioned the stability-oriented policy contained in Q2 and had called for slower disinflation and an autonomous depreciation of the currency in its stead, claimed that the independence of the central bank was being threatened by an ‘authoritarian’ government. For the social-democrat business elite, which was still reeling from the shock of ERM entry, the pressure on the monetary authority suggested a reversal of macroeconomic policy. There were no negative international repercussions and the ERM partners believed that the code of conduct would be upheld, but the domestic controversy served to slow the learning process among firms and citizens about the benefits to be derived from an improved financial reputation. In the turbulence that followed ERM entry, the lack of credit familiarity within Portugal also had to be overcome. Nonetheless, in tandem with favouring capital controls, the central bank discouraged international borrowing, which it still associated with looming payments crises rather than promoting the country’s credit abroad. Exceptionally high foreign exchange reserves were another legacy, and were therefore not used to boost the Treasury’s credit rating. Portugal’s external debt issues had been assigned a rating of A1 by Moody’s Investor Services in late 1986 and an A by Standard and Poor’s two years later. The discrepancy between the two agencies’ ratings remained until late 1991, when Standard and Poor’s upgraded their rating to A⫹. As soon as the currency became fully convertible a strategy for raising the Treasury’s profile in international markets was designed. This involved the planned return to international borrowing, successively in yen, marks and dollars. Standard and Poor’s upgraded Portugal’s foreign debt to AA⫺ in May 1993, even though the previous upgrade had been made less than 18 months earlier. At the time international investors believed that economic policy in Portugal would retain a medium-term orientation because that was what had happened in Ireland when it was upgraded in 1989. Nevertheless the strategy was ignored domestically. Shortly after the global dollar issue in September 1993, while non-interest expenditure was kept at the nominal amount laid down in Q2 the deficit increased, which had a much greater impact domestically than the credibility earned abroad.11 The ERM crises were felt by the lira and the pound sterling, and both currencies left the grid on 17 September 1992 when the peseta realigned but the escudo did not. The central bank favoured denying the ‘geographic fundamentals’ and sticking to Deutschmark shadowing, while recognizing that exchange rate policy was a government concern. Exporters, on the other hand, were impressed by the bilateral rate with the peseta and had been pressing for a devaluation of the escudo relative to the peseta. As it turned out the realignment of 23 November 1992 was matched and those of 14 May 1993 and 6 March 1995 partly followed suit, without suffering the loss in financial reputation associated with initiating a realignment. Quarterly data on capital flows suggest that external credibility was achieved in late 1992

254 Moving the Escudo into the Euro

and was unaffected by subsequent peseta realignments. As there had been no speculative attacks against the escudo, the domestic turbulence of March 1993 may have simply reflected tension between the Treasury and the central bank or echoed the banking community’s fears about the liberalization of capital movements. On the other hand it probably would not have been possible to enforce the more flexible policy of following the realignments of the peseta as smoothly without a requisite change in the bank’s operating procedures. In Table 9.1 the very low volatility state is shown to be immediately prior to the first realignment of the escudo (from 7 October to 4 November 1992), Table 9.1 Chronology of the ERM crisis regime from entry to the first realignment (per cent) Smoothed probabilities (%) Date

Mn. rtrn (% p.w.)

Cond. sd (% p.w.)

Very low

High

Very high

04/08/92 04/15/92 04/22/92 04/29/92 05/06/92 05/13/92 05/20/92 05/27/92 06/03/92 06/11/92 06/17/92 06/24/92 07/01/92 07/08/92 07/15/92 07/22/92 07/29/92 08/05/92 08/12/92 08/19/92 08/26/92 09/02/92 09/09/92 09/16/92 09/23/92 09/30/92 10/07/92 10/14/92 10/21/92 10/28/92

⫺0.53 0.06 ⫺0.80 ⫺1.08 ⫺0.68 ⫺0.65 0.00 ⫺0.21 0.06 0.32 ⫺0.27 ⫺0.03 0.49 0.72 1.22 0.22 ⫺0.42 0.41 0.35 1.30 0.72 0.30 0.00 0.70 ⫺0.13 0.78 0.28 0.12 0.01 0.02

0.19 0.38 0.33 0.55 0.62 0.53 0.51 0.43 0.40 0.37 0.37 0.39 0.35 0.41 0.44 0.65 0.51 0.52 0.52 0.44 0.78 0.65 0.54 0.45 0.57 0.49 0.65 0.49 0.31 0.15

– – – – – – – – – – – – – – – – – – – – – – – – – – 89 94 95 94

85 82 71 71 81 87 92 94 94 92 88 82 63 45 27 31 28 24 19 5 20 27 25 15 12 4 4 5 5 6

13 17 29 29 18 13 7 5 5 7 11 18 37 55 73 69 72 76 81 95 80 73 75 85 88 96 6 1 – –

Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas 255 Table 9.1 Continued Smoothed probabilities (%) Date

Mn. rtrn (% p.w.)

Cond. sd (% p.w.)

Very low

High

Very high

11/04/92 11/11/92 11/18/92 11/25/92

0.03 ⫺0.32 0.12 0.59

0.08 0.06 0.36 0.36

85 – – –

15 100 98 96

– – 2 4

Notes: The ‘low’ and ‘medium’ volatility states were negligible. Probabilities may not add up to 100 due to rounding.

switching to high volatility in the week starting 11 November while the conditional standard deviation dropped from 0.65 per cent to 0.06 per cent per week. During this episode of what might be called ‘false stability’, the central bank used strong market intervention to keep the rate glued to the top of the band before adjusting the central rate. While this interpretation of the central bank’s response to speculative attacks should be tested further with appropriate intervention data, it is consistent with the presumption in the previous section that the decision to enter the ERM could not have been taken much later than April 1992, and that – given the absence of a MAFAS and a PPERR – an earlier entry date would not have been possible either. Indeed the reason why the specification with five states (see Appendix 9.1) is more adequate than that with four states is that the latter allows the identification of state 1 with fully credible economic and monetary policies, ruling out the case of ‘false stability’. Table 9.2 confirms that the impact of the other decisions mentioned in this section (especially those on 16 December and 3 March, or even at the time of the second realignment, when the probability of a very high volatility state leapt from 40 per cent to 90 per cent) was not comparable to that of the first realignment.

Conclusion When Portugal achieved political stability in 1987, some two years after joining the European Community, the national economic environment was still inflationary. Moreover the change in regime towards a stability-oriented macroeconomic policy was conducted at a time when the ERM parity grid was under severe strain. Despite this, thanks to the efforts of successive finance ministers and central bank governors working in tandem, the criteria for economic and monetary union were met and the euro conversion rate was set at 200 escudos. This rate represented a depreciation of some 16 per cent of the one prevailing at the time the escudo entered the ECU basket in 1989, which had mostly been determined by realignments initiated by the

256 Table 9.2 Chronology of the ERM crisis regime from the first realignment to the widening of the bands (per cent) Smoothed probabilities (%) Date

Mn. rtrn (% p.w.)

Cond. sd (% p.w.)

High

Very high

12/02/92 12/09/92 12/16/92 12/23/92 12/30/92 01/06/93 01/13/93 01/20/93 01/27/93 02/03/93 02/10/93 02/17/93 02/24/93 03/03/93 03/10/93 03/17/93 03/24/93 03/31/93 04/07/93 04/14/93 04/21/93 04/28/93 05/05/93 05/12/93 05/19/93 05/26/93 06/02/93 06/09/93 06/16/93 06/23/93 06/30/93 07/07/93 07/14/93 07/21/93 07/28/93 08/04/93

0.09 ⫺0.39 0.22 0.88 0.39 ⫺0.55 ⫺0.40 0.37 0.35 0.17 0.16 0.84 0.70 ⫺0.23 0.44 0.22 0.40 ⫺0.15 0.14 0.04 ⫺0.27 0.16 ⫺0.10 0.89 2.08 ⫺0.13 0.92 ⫺1.43 0.32 ⫺0.38 0.48 ⫺0.01 1.29 1.72 3.00 1.00

0.42 0.37 0.40 0.39 0.54 0.42 0.54 0.45 0.47 0.41 0.37 0.35 0.52 0.46 0.45 0.46 0.39 0.39 0.38 0.36 0.34 0.36 0.35 0.34 0.59 0.87 0.73 0.76 0.86 0.73 0.67 0.67 0.56 0.80 0.80 0.98

95 92 89 81 85 84 90 92 94 95 93 87 90 92 94 96 97 97 96 95 90 81 61 10 – – – – 2 4 4 4 – – – 43

5 8 11 19 15 16 10 8 6 5 7 13 10 8 6 3 3 3 3 4 9 19 39 90 100 100 100 100 98 96 96 96 100 100 100 57

Notes: The other volatility states were negligible. Probabilities may not add up to 100 due to rounding.

Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas 257

peseta. The understanding shown by the Portuguese authorities for the ERM code of conduct as they prepared to join after the general election of 1991 enabled Portugal to acquire a sound financial reputation very quickly. This understanding was made clear by the priorities set during the Portuguese presidency of ECOFIN in the first semester of 1992, in the course of which public communiqués on multilateral surveillance were issued. However there was tension between several ministers and central bank governors with regard to banking supervision issues as well as the timing of ERM entry, the speed at which to move to full currency convertibility and whether the escudo should respond to peseta realignments. The weekly escudo/Deutschmark exchange rate figures suggest that the six successive exchange rate regimes were accompanied by at least three episodes of volatility. Before entering ERM, a crawling peg was discreetly replaced by Deutschmark shadowing, with reinforced controls on capital inflows at the beginning of the first stage of economic and monetary union. Yet the escudo/Deutschmark exchange rate proved more stable in the ERM than when it had been non-convertible and the central bank had controlled the currency (although in November 1992 intervention by the central bank had been so strong that it had induced a ‘false stability’). The comparison in Table 9.4 excludes the crisis regime before the bands were widened, as well as the period after volatility had subsided in respect of those currencies with prospects of qualifying for EMU. A non-convertible currency should tend to be less volatile than a convertible currency, but the results for the escudo show the exact opposite. Conditional volatility was 0.3 per cent and 0.43 per cent per week in the first and second subperiods respectively, whereas during two subperiods after the ERM bands were widened and separated by the last realignment it was 0. 28 per cent and 0.4 per cent per week respectively. During the ERM crises volatility reached 0.47 per cent, but it fell to 0.08 per cent per week after October 1997. Finally, with regard to the alternation of international and domestic objectives in macroeconomic policy making associated with the task of moving the escudo into the euro, this pattern could re-emerge if the threat of a ‘euro hold-up’ arises, perhaps as a consequence of turbulent world financial markets. Appendix 9.1: estimating volatility states In this appendix we examine time-series data on the escudo/Deutschmark exchange rate in order to evaluate whether different exchange rate regimes were accompanied by different states of volatility. Here the exchange rate regimes discussed in the second section of this chapter will be ranked in terms of the volatility of the escudo/Deutschmark exchange rate. The data are derived from 614 observations of the average value of the spot exchange rates published each week by the Banco de Portugal over the period 7 January 1987 to 15 October 1998. Given the non-stationarity of the data we shall work with the first differences of the series. The log difference in the weekly rate in per cent, denoted

258 Moving the Escudo into the Euro by yt, exhibits serial correlation, time dependent variances and heavy tails.12 A specification that captures the auto-correlation in yt is the AR(1) process: yt ⫽ ␣ ⫹ ␾yt ⫺ 1 ⫹ ut,

ut i.i.d. N(0, ␴2),

(9.1)

where the residuals are normal and identically and independently distributed. The condition for covariance stationarity, |␾| ⬍ 1, implies that yt has a constant (conditional and unconditional) variance given by ␴2/(1 ⫺ ␾2). If |␾| ⱖ 1 then yt will diverge and its (conditional and unconditional) variance will be infinite. Therefore the assumption about the error term is too restrictive to capture the clear clustering of volatility over time that is apparent in the data. The standard models to deal with this problem are the generalized autoregressive conditional heteroskedasticity (GARCH) specifications, where the conditional variance of the residual depends linearly on past realizations. A Gaussian GARCH(1,1) process for the residual ut is widely used. It is characterized by ut ⫽ ht vt

vt i.i.d. N(0,1) 2 2 ht ⫽ ␬ ⫹ ␦h t ⫺ 1 ⫹ ␤u2t ⫺ 1

(9.2) (9.3)

It is clear from Equation 9.2 that the conditional variance of ut is now given by ht2 rather than the constant ␴2. According to Equation 9.3 this conditional variance at time t depends on the past conditional variance and the squared past residual. This specification by itself does not ensure that the estimated model satisfies the nonnegativity of ht2. A sufficient condition for the variance not to be negative is ␬ ⱖ 0, ␦ ⱖ 0, ␤ ⱖ 0, and the process is covariance stationary if ␦ ⫹ ␤ ⬍ 1. Otherwise the unconditional variance of the error will be infinite. Also, a measure of the persistence of errors on future volatility is given by ␦ ⫹ ␤. If this quantity is equal to zero, future volatility is not affected by any shock, so that the variance is constant and equal to ␬ (or ␴2 in the earlier specification). As ␦ ⫹ ␤ approaches one, the effect of shocks on future volatility persists longer. When the sum equals one, any shock to volatility will be permanent. If the above sum is greater than one, this implies an exploding variance in the presence of shocks. The usual way of estimating the unknown parameters of the model is the method of maximum likelihood. The sample log-likelihood function can be written as the sum of the log conditional densities: L ⫽ ⌺ln f(yt | yt ⫺ 1, yt ⫺ 2,…)

(9.4)

where the above sum goes from t ⫽ 1 to t ⫽ T. Because we have assumed that vt is normally distributed, each of the terms in the sum is given by ln f(yt | yt ⫺ 1, yt ⫺ 2, …) ⫽ ⫺ 0.5ln(2␲ ht2) ⫺ (yt ⫺ ␣ ⫺ ␾ yt ⫺ 1)2/ ht2

(9.5)

To find the vector of parameters that maximize L, a numerical maximization procedure was followed using the BFGS (Broyden, Fletcher, Goldfarb and Shanno) algorithm. Given an initial set of parameter values (␣, ␾, ␬, ␦, ␤), this procedure finds the maximum of L by iteration. In this case, however, an additional restriction must be imposed on ␬, to avoid negative values of ht2. When ␬ is fixed at zero, its optimal value, the estimated values of ␦ and ␤ are such that their sum is greater than one.13 None of these results is consistent with the short-lived surges in the volatility of the weekly percentage change of the escudo/Deutschmark exchange rate. A possible explanation for the failure of the GARCH specification to model volatility in our case, is that these models are not appropriate in the presence of structural changes in the series. Both poor forecasting results and spurious high estimated persistences result from the

Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas 259 GARCH specification, and consequently Hamilton and Susmel (1994) propose a more parsimonious model called the SWARCH model, which allows for structural change in the scale of the conditional variance specification. The location of the regimes is estimated by the model itself, given the number of states K. Consider a model where the residual ut follows a K-state Markov switching ARCH(2) process: ut ⫽ gst0.5 et

(9.6)

with et following the traditional ARCH(2) model, where unlike the GARCH model in Equation 9.3 past variances do not appear on the right-hand side, only squared residuals lagged for one and two periods: et ⫽ ht vt

vt i.i.d. N(0,1)

ht2 ⫽ ␣0 ⫹ ␣1 et2⫺ 1 ⫹ ␣2 e2t ⫺ 2

(9.7) (9.8)

The variable st takes a value in {1,2,3, … ,K} and denotes the state that the process is in at date t. The gst denote how the scale of the process differs over the different states. The variance factor for state 1 is normalized at unity, g1 ⫽ 1, with gj ⬎ 1 for j ⫽ 2,3,…,K. From Equation 9.6 it can be seen that et2 ⫽ ut2/gst. Therefore the variance of the residual ut, given the current and past states, is E(u 2t |st, st ⫺ 1, st ⫺ 2, ut ⫺ 1, ut ⫺ 2) ⫽ gst (␣0 ⫹ ␣1 [u 2t ⫺ 1/gst ⫺ 1] ⫹ ␣2 [u 2t ⫺ 2/gst ⫺ 2])

(9.9)

When there is just one state (st is always equal to 1, gst is also equal to 1 and et ⫽ ut) the above expression simplifies to an ARCH(2) model: E(ut2| ut ⫺ 1, ut ⫺ 2) ⫽ ␣0 ⫹ ␣1 u2t ⫺ 1 ⫹ ␣2 u2t ⫺ 2

(9.10)

It is assumed that st follows a Markov switching process with transition probabilities given by a K ⫻ K matrix P. The row j, column i element of P represents the probability of going from state i to state j: pij ⫽ Prob(st ⫹ 1 ⫽ j, st ⫽ i)

(9.11)

for i, j ⫽ 1,2,3,4. To ensure consistency, each column of P should sum to one. In the SWARCH model the sample log-likelihood function can also be written as the product of the log-conditional densities, as in Equation 9.4 above. To compute each of these terms, a recursive process is used (see Appendix to Braga de Macedo et al., 1999) to compute the probability of being in each of the K states. Given the values of all the parameters of the model – ␣, ␾, ␣0, ␣1, ␣2, the K ⫺ 1 variance factors g and the elements in P – the likelihood function can be evaluated by this recursive method. The maximum likelihood estimator of these parameters can then be computed using a numerical optimization algorithm, such as the GAUSS code provided by Hamilton (1994). Using the maximum likelihood estimator of the parameters, Hamilton describes a procedure for estimating probabilities about the particular state that process st was in at any date t using the full sample t ⫽ 1,2, … ,T. These ‘smoothed probabilities’ for j ⫽ 1,2,3,…,K are reported below. They can be written as: p(st ⫽ j | yT, yT ⫺ 1, …)

(9.12)

Braga de Macedo (2001, p. 257) reports the results of earlier work, applying the SWARCH model with three states using daily data on the escudo/Deutschmarkexchange rate until 19 April 1997. Re-estimating this model with the new data did not prove possible as the maximization procedure did not converge. Covas (1998) used weekly data for the rates of the escudo, the peseta, the punt, the lira and the markka

260 Moving the Escudo into the Euro against the dollar until May 1998. As economic and monetary union on a broad scale became fully credible in late 1997, a new regime with almost zero volatility seems to have emerged. This was to be expected from approximate measures of the likelihood of economic and monetary union beginning on time and the list of countries most likely to be included being gleaned from how strong market-makers’ expectations were of interest rates being equalized. Goldman Sachs used the difference between the forward rates on ECU instruments and its component currencies to evaluate economic and monetary union, and J. P. Morgan produced a calculator using swaps of floating interest rate instruments into fixed interest rate instruments to estimate the probabilities of individual currencies. According to these estimates, the probability of economic and monetary union becoming a reality rose from 80 per cent during most of 1997 to 100 per cent in mid October 1998, when the probability of the escudo moving into the euro reached 95 per cent, the highest level among eight non-core European currencies. We have considered SWARCH models with up to five states. The results of the estimated models were compared with the constant variance case, even though there was no nesting of the hypotheses underlying the GARCH(1,1) and SWARCH specifications. The first column of Table 9.3 shows the percentage improvement in mean square error (MSE) from one-step-ahead forecasting performance, which Hamilton and Susmel (1994) compare with R2. The second column reports the variance factor for the highest volatility state (5, 4, 3 or 2) on the presumption that it is set to one even in the GARCH(1,1) model. The differences in the scale of volatility are quite significant, exceeding 800 for the SWARCH(4,2) model. Some of the SWARCH models were simplified by imposing a coefficient of zero for those probabilities in matrix P that were almost zero. The value of the likelihood function did not change significantly. A SWARCH(5,2) model was also estimated, but a corner solution was obtained for the ␣2 parameter in Equation 9.8, leading to the SWARCH(5,1) model reported. The SWARCH(2,2) model showed very little improvement over the mis-specified GARCH(1,1) model, and the one-week-ahead forecasting performance was 11 per cent worse than that of a constant variance model. With more than two states, the SWARCH models all improved the forecasting performance. However the SWARCH(4,2) model was worse than the SWARCH(3,2) model in terms of mean absolute error, and the SWARCH(5,1) showed almost no improvement in the log-likelihood function.14 In the first column of Table 9.4 the average standard deviation over the six regimes is ranked from very low to very high volatility. Even though a non-convertible currency, which is not market-determined, will tend to be less volatile than a convertible currency, the first column shows a conditional volatility of 0.3 per cent and 0.43 per cent per week in the first and second subperiods respectively, whereas during two subperiods Table 9.3 Comparisons relative to constant variance model

Model GARCH(1,1) SWARCH(2,2) SWARCH(3,2) SWARCH(4,2) SWARCH(5,1)

MSE (%) ⫺1 ⫺11 1 4 10

Highest var. factor 1 23 236 823 725

Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas 261 Table 9.4 Average standard deviation and probabilities of states in regimes Average smoothed probabilities of five states (%) Av. condit sd. (% p.w.) 0.08 0.28 0.30 0.40 0.43 0.47

Regime label EMU Peseta Crawling peg Band widening Deutschmark shadowing Crisis

Very low

Low

Medium

High

Very high

86 0 0 0 0

14 14 7 0 0

0 54 49 17 5

0 30 43 70 71

0 2 1 12 24

7

0

0

54

39

after the ERM bands had been widened and separated by the last realignment, conditional volatility was 0.28 per cent and 0.4 per cent per week respectively. During the ERM crisis, volatility reached 0.47 per cent, but it fell to 0.08 per cent per week after October 1997. The second column of Table 9.4 shows the average smoothed probabilities in each regime, arranged to underline the correspondence between states and regimes. This correspondence was most apparent in the regime prior to economic and monetary union and it provides a measure of the credibility of the final year of transition to stage three, since ‘own’ probability was highest at 86 per cent. The crisis regime corresponded both to the high and to the very high volatility states, with probabilities of 54 per cent and 39 per cent respectively, but both the band widening and the Deutschmark regimes corresponded to the high volatility state, with a probability of about 70 per cent. The medium volatility regime corresponded to the peseta and the crawling pegregimes, with probabilities of around 50 per cent. The fact that the low volatility state had no strong correspondence with any one of the more stable regimes reflects the fact that both states 4 and 5 were adequate models for these regimes. The estimated matrix of transition probabilities for the SWARCH(5,1) model revealed that the very low volatility state was the most stable (97.5 per cent), while the highest volatility state was the least stable (84.5 per cent). The low volatility state was less stable (93.3 per cent), allowing a 2.6 per cent probability of shifting to the very low volatility state and a 4.1 per cent probability of moving to the medium volatility state. States 3 and 4 dominated most of the sample period, but state 4 was interrupted by switches to the ‘crisis’ state, with a probability of 3.4 per cent. The results for the SWARCH(4,2) model were very similar, except that the last period in the sample belonged to a completely separate regime from that of the past. In this model state 4 was the crisis state, and the most short-lived (79.1 per cent). States 2 (low volatility) and 3 (high volatility) alternated throughout most of the sample period. The low volatility state that obtained before economic and monetary union was deemed fully credible was also very stable (97.6 per cent), but there was a 0.8 per cent probability of it shifting to the high volatility state and a 1.2 per cent probability of it shifting to the very low volatility state. The high volatility state had an own-probability of 95.6 per cent and the transition to the high volatility state was 2.9 per cent, larger than that of shifting to the low volatility state (1.6 per cent). The model with three states produced a variance factor for the medium volatility state that was almost the same as the low state in the model with four states. The smoothed probabilities were also very close to those obtained with the previous model. The high volatility state was a mixture of the high and very high

262 Moving the Escudo into the Euro volatility states in the SWARCH(4,2) model. Therefore a model with three states can identify a regime when economic and monetary union becomes fully credible, but does not allow for crises. As already mentioned, there is no appropriate model with less than three states: in the estimated SWARCH(2,2) model, the low volatility state at the end of the sample period was not defined separately from other low volatility states and it was less stable than the high volatility state. In summary, an examination of the weekly escudo/Deutschmark exchange rate series suggests that six successive exchange rate regimes were accompanied by widely different states of volatility. Before Portugal entered the ERM a crawling peg was discreetly replaced by Deutschmark shadowing, with reinforced controls on capital inflows at the beginning of the first stage of EMU. Even allowing for the final realignment, the escudo/Deutschmark exchange rate was more stable in ERM than when it had been nonconvertible and the central bank controlled the currency. The comparison excluded the crisis regime before the bands were widened and the subperiod after those currencies which were likely to qualify for EMU became less volatile. Both regimes were captured by Markov switching autoregressive conditional heteroskedasticity (SWARCH) models with more than three states. The specification with five states was favoured because it indicated the nature of the central bank’s response to speculative attacks. This remained the case when the model was re-estimated to include the period before 30 December 1998. According to Braga de Macedo et al. (2003), after the abandonment of the crawling peg the escudo behaved as if it were in a credible target zone. Thanks to data provided by the Banco de Portugal these authors were able to reduce the number of states from five to three when they re-estimated the SWARCH model with additional explanatory variables, overcoming the problems raised also in connection with previous studies on the escudo exchange rate.

Notes 1. Partial research support was provided by an ICCTI-EHESS project managed by the first author and François Bourguignon. Earlier versions of this chapter appeared as Braga de Macedo et al. (1999), Nova Economics Working Paper no. 346, February 1999, and DELTA Document de Travail no. 1999–14. See also Braga de Macedo (2001 and 2003). 2. The escudo was created after the Republican revolution of 1910. Like the real it replaced at par (1 to 1000), the escudo remained non-convertible, but it stabilized in 1931 at a rate of around 25 to the dollar. From the 1974 revolution until accession to the European Community in 1985, the parity (measured against the ECU) changed from 30 to 130 escudos. See Braga de Macedo et al. (1996) for a discussion of the Portuguese currency experience. 3. The call for a MAFAS by Bliss and Braga de Macedo (1990) reflects the latter author’s experience with the multilateral supervision procedures at the European Commission in Brussels, together with a criticism of the ambiguous response to the challenge of European integration prevailing in the late 1980s. 4. In a financial system highly protected from competition and facing weak supervision, central bank policy increasingly depended on issuing short-term domestic debt to mop up the growing capital inflows attracted by the highly remunerative real interest rates to be earned on pure arbitrage operations. 5. To stress the departure from DM shadowing, parity was declared in terms of ECU. While welcomed by the Commission, the innovation was frowned upon by the Bundesbank representative.

Jorge Braga de Macedo, Luís Catela Nunes and Francisco Covas 263 6. During the debate the opposition criticized the move and one socialist MP even claimed that Britain had presented an ‘ultimatum’, similar to that in 1890 which, while unrelated, had preceded the exit from the gold standard. Actually, the combination of financial discipline and political stability in a multiparty democracy had not been seen since. 7. The minister/governor duo was as durable and uneventful as the first duo, certainly relative to the other five: Beleza/Moreira (almost two years), Macedo/Beleza and Catroga/Sousa (about eighteen months), Macedo/Moreira and Catroga/Beleza (about six months). Braga de Macedo (2001) reports results on the decomposition of real interest rate differentials relative to the dollar and the Deutschmark according to the mandates of minister/governor duos. See also Rocha de Sousa (1997). 8. There was a major difference between the two mid-term cabinet reshuffles: the reshuffle in 1990 helped the Social Democratic Party to reinvigorate itself and go on to win the 1991 elections, but the reshuffle in 1993 did not. Admittedly the fact that the new economic regime was in place in 1993 made it less costly for the prime minister to halt reforms and simply attempt to finish his term, once he had publicly announced in February 1995 that he would not stand as prime minister in the general election the following October. 9. The Foreign Exchange Law and the Statute of the central bank are further examples of structural reforms prepared by Cadilhe but passed during Beleza’s term as minister. Tax administration procedures and the resolution of disputes, involving the privatization of Banco Totta and Petrogal, are similar examples for Catroga’s term. 10. Both teams met regularly (and minutes were kept, but not published), and the ministry team also convened an informal council including a dozen former ministers of finance, where four other former governors who had also been ministers (Pinto Barbosa before the revolution, Silva Lopes, Victor Constancio and Beleza thereafter) were able to debate the state of the economy and progress towards convergence. 11. Euromoney credited Macedo when nominating Portugal as ‘Borrower of the Year 1993’. Note that previous practice had directly involved the minister/governor duo in foreign debt issuing. 12. The heavy tails can be detected by the high value of the kurtosis in Table 9.3, which may invalidate (or reduce the power of) the results of the Ljung–Box test statistic for autocorrelation. Nevertheless the Ljung–Box test statistics suggest that there is serial correlation in the series and in the squared residuals. The ARCH tests also indicate the presence of strong heteroskedasticity in the data. 13. A graph of the maximum log-likelihood holding the parameter ␬ fixed at several non-negative values shows that the optimal value of ␬ with the non-negativity constraint for the variance imposed, is equal to zero. When ␬ is fixed at zero, the estimated values of ␦ and ␤ do not satisfy the covariance stationarity condition as their sum is greater than one (Table 9.4). The failure of the above conditions were also obtained under all other GARCH and ARCH models estimated for the same data but not reported. 14. The MSE in Table 9.3 refers to the loss function measuring the one-step-ahead forecast performance described in Hamilton and Susmel (1994), who also present the appropriate measure of persistence, following the solution of the secondorder-difference equation for the conditional variance implied by the ARCH(2) component of the SWARCH model in Equation 9.8. The degrees of persistence

264 Moving the Escudo into the Euro suggested by the estimated SWARCH models are clearly less than the large persistence suggested by a GARCH(1,1) model. Moreover as the number of states increases, persistence decreases. This result suggests that the problems with the GARCH(1,1) specification may be due to the presence of neglected states.

References Bliss, Christopher and Jorge Braga de Macedo (eds) (1990) Unity with Diversity in the European Economy: The Community’s Southern Frontier (Cambridge: Cambridge University Press). Braga de Macedo, Jorge (2001) ‘Crises? What Crises? Escudo from ECU to EMU’, in Stephany Griffith-Jones, Manuel F. Montes and Anwar Nasution (eds), Short-Term Capital Flows and Economic Crises (Oxford: Oxford University Press), pp. 251–62. Braga de Macedo, Jorge (2003) ’Portugal’s European Integration: the Good Student with a Bad Fiscal Constitution’, South European Society and Politics, vol. 8, nos 1–2, pp. 165–94. Braga de Macedo, Jorge, Barry Eichengreen and Jaime Reis (eds) (1996) Currency Convertibility: The Gold Standard and Beyond (London: Routledge). Braga de Macedo, Jorge, Luís Catela Nunes and Francisco Covas (1999), ‘Moving the Escudo into the Euro’, CEPR Discussion Paper no. 2248 (London: CEPR, October). Braga de Macedo, Jorge, Luís Catela Nunes and Luís Brites Pereira (2003) ‘Central Bank Interventions under Target Zones: The Portuguese Escudo in the ERM’, Nova Economics Working Paper, no. 435, Lisbon, September. Covas, Francisco (1998) ‘Regime Switching in Exchange Rates’, unpublished paper, Nova University, Lisbon, July. Hamilton, James D. (1994) Time Series Analysis (Princeton, NJ: Princeton University Press). Hamilton, James and Raul Susmel (1994) ‘Autoregressive Conditional Heteroskedasticity and Changes in Regime’, Journal of Econometrics, vol. 64, pp. 307–333. Rocha de Sousa, Miguel (1997) ‘Real Interest Rate Differentials and Regime Change in Portugal 1989–1997’, unpublished paper, Nova University, Lisbon, June.

10 The Experience of Greece: Delayed Adjustment Loukas Tsoukalis

Greece’s accession to the EC in 1981, marked the end of a period of almost 20 years in which relations with the EC-6 and later the EC-9 were governed by the most comprehensive Association Agreement ever signed by the EC with a third country (Tsoukalis, 1981). The period of membership can be divided into two distinct subperiods: the first one ending in the late 1980s or early 1990s (depending on the criterion used), and the second from then to the present day. The first subperiod was characterized by a significant deterioration of Greece’s economic performance, which also coincided with difficult relations with the rest of the EC/EU (Kazakos and Ioakimidis, 1994; Featherstone and Ifantis, 1996; Allison and Nicolaidis, 1997). During those years Greece was often portrayed as an awkward partner and an example to avoid. An obvious question is whether there was any link between accession to the EC and bad economic performance; and what lessons, if any, can be drawn for the new accession countries. The dramatic improvement of Greece’s macroeconomic situation from 1993, which was accompanied by a more general shift in Greece’s European policy, provides some scope for comparison.

Long-term trends Table 10.1 compares Greece’s economic performance with that of the EU-15 between 1961 (the year when the Association Agreement was signed with the EC-6) and 2002. Table 10.1 contains the figures for four variables: real GDP growth, gross fixed capital formation as a share of GDP, unemployment, and inflation (consumer prices). The figures are quite revealing. In the two decades prior to EC accession the growth of the Greek economy was much faster than the average growth of the EU countries. Exactly the opposite pertained during the first ten years 265

266 The Experience of Greece Table 10.1 Main economic indicators: long-term trends, 1961–2002 (per cent)

Growth rate of GDP Greece EU-15

1961–70

1971–80

1981–90

1991–2002

8.5 4.8

4.6 2.9

0.7 2.4

2.6 2.0

22.9 21.0

21.0 20.1

Gross fixed capital formation (as a share of GDP) Greece 23.0 28.2 EU-15 23.8 23.4 Unemployment rate Greece EU-15

5.0 2.0

2.2 3.8

6.4 8.5

9.6 9.1

Inflation rate Greece EU-15

2.4 3.8

13.9 10.0

19.0 6.3

8.3 2.8

Source: European Commission.

of Greece’s membership, although it began to catch up with the other countries in the 1990s. The major decline in the growth rate was reflected in the figures for gross fixed capital formation, although here Greece did slightly better than the EU-15 throughout the period. With regard to inflation, the deterioration of Greece’s performance during the 1980s was very strong, as was its divergence from the rest of the EU, which continued well into the 1990s despite the improvement in GDP and fixed capital formation. Low growth and high inflation were combined with relatively low rates of unemployment, although in the 1990s Greece was quickly catching up with the rest of the EU. During much of the period in question, Greece climbed down the EU income ladder, which was to be expected given its low growth rates. According to Eurostat data for GDP at current market prices, using PPS and setting the EU-15 average at 100, Greece started at 70 in 1980, went down to 58 in 1990 and rose to 67 in 2002. Any comparison of Greece’s performance with those of Portugal and Spain is unfavourable, not to mention the spectacular case of Ireland. On the other hand high inflation, coupled with the unavoidable depreciation of the drachma during most of that period, excluded any possibility of Greece participating in the ERM. The turning point came in 1993, when Greece entered a new phase of economic stabilization and convergence with the rest of the EU, coupled with a more determined and much delayed effort at privatization and restructuring. This new phase was characterized by a substantial improvement in economic growth. Previous attempts at stabilization and restructuring had proved short-lived, and the room for manoeuvre became increasingly narrower with time. Economic marginalization in the context of the EU, the

Loukas Tsoukalis 267

rapidly rising cost of servicing the accumulated debt and the increasing difficulty with financing deficits left successive Greek governments with very limited options, and as a result membership of EMU became the main target of policy. This new phase is summarized in Figures 10.1 and 10.2. Greece’s inflation and budget deficits registered a sharp decline and rapidly converged towards the EU average (Figure 10.1). This convergence, combined with a devaluation of the drachma of 12.5 per cent, led to Greece’s admission to ERM-1 in March 1998 and subsequently to ERM-2, with a fluctuation band of 15 per cent above or below the central parity. The crowning act of macroeconomic convergence came with Greece’s admission to EMU in January 2001 after meeting the convergence criteria. Since then there has been some deterioration in terms of budgetary deficits, although they still remain below the EU average, and inflation continues to rise. Interestingly, macroeconomic stabilization has not been achieved at the expense of growth. On the contrary, growth rates have been consistently higher than the EU average since 1996, and if anything the gap has widened since 2000. However the unemployment rate has risen significantly in recent years, largely because of economic restructuring and the (still incomplete) freezing of public sector employment. Furthermore Greece has become a large net 15

10

5

0

–5

–10

–15 1993

1994

1995

1996

1997

Inflation Greece Budget deficit Greece

1998

1999

2000

2001

Inflation EU-15 Budget deficit EU-15

Figure 10.1 Convergence of Greece with the EU: inflation and budget deficits, 1993–2001 Source: European Commission.

268 The Experience of Greece 5

Annual percentage change

4

Greece

3 EU-15

2 1 0 –1 –2 1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Figure 10.2 Growth rates in Greece and EU-15, 1993–2002 (percentage of GDP per annum) Source: European Commission.

importer of labour, mainly from its northern neighbours and most notably from Albania. For a country that is traditionally one of emigration, this is truly astounding: the proportion of foreigners in Greece is currently estimated to be at least 7–8 per cent of the total population, and many of them have acquired legal status in recent years. With the benefit of hindsight, the concern expressed by EU countries prior to the accession of Greece that they would be subjected to large flows of Greek workers in search of jobs now sounds ridiculous. Greece’s openness to trade has grown since its accession, especially since the early 1990s. Figure 10.3 shows exports and imports of goods and services as a percentage of GDP for Greece and the EU-15 for the period 1981–2002. The figures include both intra- and extra-EU trade. When Greece joined the EC in 1981, Greek exports already enjoyed virtually free access to the other member countries as a result of liberalization under the Association Agreement. However the same was not true of imports from EC countries, mainly because of non-tariff protection. Replaced by the so-called regulatory tax after accession, the protective armoury was gradually dismantled during the course of the 1980s. Nonetheless, compared with the EU average Greece is still a relatively closed economy, especially given its small size. Figure 10.4 plots the figures for intra-EU trade in goods as a percentage of total trade. Greece’s dependence on intra-EU trade underwent a very large increase during the second half of the 1980s, precisely when imports from the EU were liberalized. It has reduced since then, mainly because of the

Loukas Tsoukalis 269 38 36 34 32 30 28

EU-15

26 24 Greece

22

19 8 19 1 8 19 2 8 19 3 8 19 4 8 19 5 8 19 6 8 19 7 8 19 8 8 19 9 9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 0 20 0 0 20 1 02

20

Figure 10.3 Trade openness, Greece and EU-15, 1981–2002 (average of exports and imports of goods and services as percentage of GDP) Source: European Commission.

70 68 66 64 62 60 EU-15

58 56

Greece

54 52

00

99

20

98

19

97

19

96

19

95

19

94

19

93

19

92

19

91

19

90

19

89

19

88

19

87

19

86

19

85

19

84

19

83

19

19

82

19

19

81

50

Figure 10.4 Intra-EU trade goods only, 1981–2000 (percentage of total trade) Source: European Commission.

rapid growth in trade with Greece’s Balkan neighbours after the fall of the communist regimes. The figures for Greece’s trade with non-EU countries are in fact an underestimate because some of its trade with the Balkan countries still goes unregistered. Greece’s external trade has always been characterized by an imbalance between imports and exports. Since 1981 the trade deficit has increased

270 The Experience of Greece 12 11 10 9

Greece’s trade deficit with the EU

8 7 6 Net transfers from the EU to Greece

5 4 3 2 1

00

99

20

98

19

97

19

96

19

95

19

94

19

93

19

92

19

91

19

90

19

89

19

88

19

87

19

86

19

85

19

84

19

83

19

82

19

19

19

81

0

Figure 10.5 Trade balance and transfers, EU and Greece, 1981–2000 (percentage of GDP) Sources: European Commission; Bank of Greece.

substantially, and this increase has been almost entirely due to trade with other EU countries. Figure 10.5 shows the evolution of Greece’s trade deficit with the rest of the EU, which in recent years has fluctuated between 9 per cent and 11 per cent of GDP: no small figure by any standards. Greece is a net exporter of services, most notably in tourism and shipping, which has helped to finance part of the trade deficit. The rest has been financed by capital inflows and net transfers through the EU budget, more by the latter than the former. For almost a decade EU transfers have accounted for approximately 3.5–4.5 per cent of GDP per year.

Explanatory factors Membership of the EU has meant that Greece has had to adjust to a much more competitive economic environment. With a long history of external protection that survived the customs union with the EEC, coupled with extensive government intervention in the economy, itself characterized by its arbitrary and non-transparent nature, Greece has therefore been faced with the difficult tasks of adjustment and restructuring. For several years after accession, however, domestic political developments did not match external economic requirements. Adjustment was perceived as a threat by various economic and social groups, and some of those groups possessed considerable political clout. Thus the constitution of a reform coalition proved extremely difficult, and as a result adjustment was postponed for many years (Tsoukalis, 1993, 1999; Alogoskoufis, 1995).

Loukas Tsoukalis 271

For most of the 1980s successive Greek governments behaved as though they were operating without economic constraints: they boosted domestic demand through persistent and large budget deficits that pushed the level of public debt from 24 per cent of GDP in 1980 to 90 per cent in 1990; refused to restructure while continuing to subsidize the large and highly inefficient section of the economy under state control, which included a very large proportion of the financial sector; and generally pursued policies that created a highly unfavourable environment for private business. The new economic orthodoxy of the 1980s, resting on the twin pillars of macroeconomic stabilization and privatization, arrived in Greece much later than in the rest of the EU. This was a major factor behind the large economic divergence between Greece and the other EU countries until the early 1990s. Greece has not been able to attract much foreign investment. In the period 1986–91 the total amount of FDI inflows was less than half the amount of transfers from the Structural Funds (in contrast for Ireland they were more than three times as large). Things have not improved dramatically since then. Geography and the structure of domestic industry are, of course, important explanatory factors in the relative importance of FDI flows to a particular country – plus the English language in the case of Ireland. But so too are factors such as taxation, the state of the labour market and the macroeconomic environment, not to mention public governance standards, which are to a greater or lesser extent amenable to political decisions. Figure 10.5 above shows that net transfers from the EU have made a major contribution towards the financing of trade deficits and general investment in the country. On the other hand it can be argued that the transfer of funds – combined with improved access to borrowing from international financial markets, which in turn was linked to EU membership – gave a number of Greek governments the breathing space needed to postpone adjustment.

Tentative conclusions First, EU membership entails a difficult adjustment process, which is much harder for economies starting with a relatively high rate of external protection and extensive government intervention in the economy. Second, adjustment is likely to involve a large number of losers, some of whom may also be politically powerful. Third, domestic political processes have an autonomy of their own, and therefore do not always conform, or at least not in the short and medium term, to external economic requirements. Fourth, improved access to EU transfers and borrowing should aid economic development. If they are inappropriately used, however, these extra funds may help to postpone the adjustment required. Fifth, macroeconomic stabilization is not necessarily achieved at the expense of economic growth. Once set in motion the process can be very rapid indeed. Finally, fears about mass labour migration across frontiers may be grossly exaggerated.

272 The Experience of Greece

The above conclusions, drawn from the experience of Greece as a member of the EU, may be of relevance to several of the candidate countries in Central and Eastern Europe. References Allison, Graham T. and Kalypso Nicolaidis (1997) The Greek Paradox: Promise vs. Performance (London: MIT Press). Alogoskoufis, George (1995) ‘The Two Faces of Janus: Institutions, Policy Regimes and Macroeconomic Performance in Greece’, Economic Policy, vol. 20, pp. 148–192. Featherstone, Kevin and Kostas Ifantis (1996) Greece in a Changing Europe: Between European Integration and Balkan Disintegration? (Manchester: Manchester University Press). Kazakos, Panos and P. C. Ioakimidis (1994) Greece and EC Membership Evaluated (London: Pinter). Tsoukalis, Loukas (1981) The European Community and its Mediterranean Enlargement (London: Allen and Unwin). Tsoukalis, Loukas (1993) I Ellada kai I Europaiki Koinotita: I Proklisi tis Prosarmogis (Greece and the European Community: The Challenge of Adjustment) (Athens: Papazissis for the Hellenic Centre for European Studies). Tsoukalis, Loukas (1999) ‘Greece in the EU: Domestic Reform Coalitions, External Constraints and High Politics’, in A. Mitsos and E. Mossialos (eds), Contemporary Greece and Europe (London: Ashgate Press).

Part V Growing Disparities in Europe

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11 The Impact of EU Enlargement on Economic Disparities in Central and Eastern Europe Dariusz K. Rosati1

Introduction The process of European political and economic integration is now being extended to Central and Eastern Europe. Eight countries from Central Europe will soon join the EU, and some have already been admitted to NATO and the OECD. This integration has been made possible by broad economic and political reforms that have led to the rapid institutional convergence of Central and East European countries (CEECs) towards Western economic and political institutions. The latter is a welcome phenomenon as it diminishes the risk of conflicts arising from ideological and systemic differences between countries. It has also caused many observers and politicians to believe that, after centuries of wars, conflicts and divisions, Europe at last has the chance to become an area of peace and stability. But the European continent is still far from being homogeneous and conflict-free. First, different cultural norms and the historical experiences of the individual countries have resulted in widely diversified political traditions across the region, with varying degrees of understanding and support for democratic institutions and the rule of law. Second, deeply rooted nationalist sentiments and ethnic animosities have not disappeared in the course of transition, and in many instances have resurged, making the process of building the post-Cold-War order more complicated and politically difficult. This has been most painfully demonstrated by the violent dismantling of former federal states such as the Soviet Union and Yugoslavia. Another major difference between countries is their level of economic development, which varies widely. These economic differences mirror historical divisions of the continent. It should be recalled that liberal capitalism during the nineteenth century and the first half of the twentieth century took strongest root in Western and Central Europe, with only a patchy presence in Eastern and Southern regions. This resulted in limited 275

276 The Impact of EU Enlargement on Economic Disparities

industrialization, less developed physical and institutional infrastructure, and weaker entrepreneurial traditions in the latter regions, which remained poor and backward relative to Western Europe. Moreover the two world wars were highly damaging to national wealth in terms of production capacity, physical and institutional infrastructure, and human capital, and thus adversely affected economic development in Eastern Europe. Finally, fortyplus years of communist rule and Soviet domination not only diverted a considerable proportion of national resources to unproductive uses, but also had a devastating effect on ‘social capital’, that is, people’s mental and social attitudes, including their sense of moral and economic discipline, social solidarity and respect for laws and public institutions. The collapse of communism may have eliminated much of the political division in Europe but it could not, by itself, reduce the economic disparities. If anything they have become more apparent since the dismantling of social protection systems and the elimination of controlled prices and hidden subsidies. So nearly 15 years after the transition began, Europe is still economically diversified, with average per capita incomes in the East being several times lower than in the West. More worryingly, it is likely that the gap will not narrow soon. Economic transition was initially associated with deep recessions, and it has since progressed at a very uneven pace across CEECs. The apparent success of some transition countries, such as Poland, Slovenia and Hungary, has been the combined result of relatively better initial conditions, including the existence of some market institutions and entrepreneurial traditions, and of generally sensible reform policies. But even those countries have only recently reached – after ten years of painful transition – their pretransition GDP levels (with the notable exception of Poland, where in 2001 GDP was 31 per cent above the 1989 level). By contrast GDP in other CEECs is still well below its pretransition level. This means those countries have lost at least a decade of economic development (without taking into account the time lost under communism). It seems that the entire group of CEECs has gradually divided into two categories: the more advanced and the less advanced reformers. This division may be further exacerbated by the enlargement of the European Union. The group of new members comprises eight countries: the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia – the CE-8. In addition most of these countries already are, or soon will be, members of NATO. The CE-8 countries will clearly be in a privileged position, but for other CEECs the prospect of their integration is less clear (except perhaps for Bulgaria and Romania). As a result a new dividing line could soon emerge on the continent, this time separating the more advanced from the less advanced transition countries. This would be an unwelcome outcome of the political breakthrough of 1989. The existing economic disparities and the emergence of two categories

Dariusz K. Rosati 277

of CEECs could become a source of tension and instability, both within the region and internationally. The danger will be even greater if the lines of economic differences overlap ethnic, national or cultural borders. With increasingly open borders, the free flow of information and weak state structures, poverty, insecurity and ethnic separatism have resurfaced and could become powerful sources of regional or even continent-wide instability. This chapter starts with an assessment of economic disparities between Western and Eastern Europe, as well as among individual CEECs. As will be discussed, there has been rather limited convergence between the two parts of the continent since 1989. Moreover the less advanced CEECs have actually fallen behind and the gap between them and the more advanced CEECs has widened significantly. The second section of the chapter examines the likely impact of EU enlargement on economic disparities among the CEECs. The key conclusion is that the current disparities in economic development across the CEECs are likely to worsen when the more advanced countries join the EU. This course of events could eventually lead to increased instability in the less advanced countries, perhaps, with negative implications for the rest of Europe.2 The last section discusses policy implications and recommendations. It is suggested that it would be in the interest of the EU to be more forthcoming and cooperative in addressing the European aspirations of other CEECs, and that the best strategy for the latter would be that of ‘quasimembership’, that is, to adopt a unilateral policy of convergence towards EU institutional and policy standards.

Disparities in the level of economic development in the CEE countries Economic disparities: the static perspective Economic disparities between the West and East European countries, as well as among the CEECs themselves, are clearly visible and can be documented in a variety of ways. In a static perspective, the disparities can be illustrated with indicators of the current levels of per capita income and various ‘wealth’ assets, be it physical or financial. The most straightforward illustration is provided by per capita GDP (Table 11.1). The official figures, calculated at officially reported (or market) exchange rates, reveal a huge gap between the EU member countries, with an average per capita GDP in 2000 of some $21 000 (current US dollars), and the CEECs (without the CIS-4), with an overall average of less than $3300. A clear gap is also visible between the CE-8 and CE-7 countries, although not as large as between the EU and the CEECs as a whole. However GDP figures converted into dollars at official market rates are not good measures of real income levels in less advanced countries because they tend to underestimate the real value of non-tradable goods and services. A more reliable indicator is per capita GDP calculated at purchasing

278 Table 11.1 EU and Central and Eastern Europe, population, per capita GDP (in US dollars) and distance from Brussels, 2000 Population (thousand) Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden United Kingdom EU-15

Per capita GDP at PPP rate

Distance (km)

15 10 39 8 58 374

211 161 340 176 890 020 626 790 298 431 860 010 470 870 830 983

23 22 30 23 21 22 10 24 18 43 23 10 14 25 24 20

018 301 393 474 978 836 597 776 744 852 001 500 153 626 046 898

26 27 27 24 24 25 16 29 23 50 25 17 19 24 23 23

765 178 627 996 223 103 501 866 626 061 657 290 472 277 509 652

1 120 0 920 1 990 300 300 2 810 940 1 520 220 210 2 090 1 550 1 550 390 1 0611

Czech Republic Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia CE-8

10 1 10 2 3 38 5 1 73

273 396 024 432 670 646 401 990 832

4 3 4 2 3 4 3 9 4

945 582 549 961 079 081 536 095 264

9 4 6 3 3 5 7 10 6

775 062 793 273 843 442 320 594 328

910 2 300 1 370 1 900 1 800 1 340 1 190 1 350 1 5201

Albania Bosnia-Herzegovina Bulgaria Croatia Macedonia (FYR) Romania Yugoslavia CE-7

3 3 8 4 2 22 10 55

113 972 170 650 024 435 640 004

1 221 n.a. 1 469 4 086 1 779 1 636 n.a. 1 860

2 853 n.a. 4 604 3 972 4 058 4 431 n.a. 4 273

2 000 1 900 2 060 1 480 2 050 2 200 1 670 1 9091

10 4 147 50 212

159 380 196 658 393

2 943 297 1 706 628 1 479

4 1 4 2 3

1 950 2 200 2 620 2 200 2 2421

Belarus Moldova Russia Ukraine CIS-4

8 10 5 5 58 82 10 3 57

Per capita GDP at market rate

Note 1. Arithmetic average distance from Brussels. Sources: CSO (2001), pp. 608–9; UNDP (2002).

398 547 531 361 946

Dariusz K. Rosati 279

power parity rates (PPP), which take into account the real value of a broad consumption basket in individual countries. With this measure the economic disparities are smaller but still very substantial: in 2000 the EU-15 had an average GDP per capita of $23 652, while the CEECs (CE-8 plus CE-7) had an average of $5450, that is, 4.3 times less (Table 11.1). As can be seen, the difference between the CE-8 and CE-7 countries, though substantial, was much smaller (1.5 times). Also the differences within particular groups show that the EU group was more homogeneous: the difference between the richest and poorest EU member countries (Luxembourg versus Greece) was about 3 to 1, whereas for the transition countries the ratio (for Slovenia and Moldova) was almost 7 to 1.3 GDP figures give only a narrow picture of the actual level of economic welfare because they ignore a number of other factors that codetermine overall welfare levels, such as the degree of environmental degradation and patterns of income distribution. But it is not easy to find alternative measures that could combine all indicators into one aggregate. One possible approach is to use the human development index (HDI), a synthetic measure developed by the UNDP. Table 11.2 shows a number of indicators that are typically used in international comparisons of development levels and living standards. In general the picture that emerges is clear – there is a large difference between the EU countries and the transition countries, and there is also a significant difference between the EU candidate countries and other CEECs. The two first indicators are life expectancy and infant mortality – two synthetic measures of the level of health care and standard of hygiene. Both indicators reveal a notable difference between the EU-15 and the CEECs: life expectancy in the transition countries is three to six years lower and infant mortality is two to four times higher. There are also intragroup differences among the CEECs, especially in the case of infant mortality. These disparities point to the potential magnitude of necessary spending on upgrading and improving the health care systems in CEECs. The next two indicators – adult literacy and gross combined school enrolment – measure the current and projected educational levels in individual countries. They can also indicate the level of available and future resources of human capital. As can be seen, there is practically no difference between the EU-15 and the CEECs in terms of adult literacy – in both groups the indicator is very high (the only exception being Albania). However school enrolment is somewhat higher in the EU countries (80–100 per cent) than in the CE-8 and CIS-4 (75–80 per cent) and much higher than in other CEECs (60–75 per cent). This indicates the need for more spending on general and professional education in the less advanced CEECs. A similar picture emerges from statistics on Internet connections – the CE-8 have three times fewer Internet hosts per capita and the CE-7 20 times fewer than the average for the EU-15.

Life expectancy1 EU-15: Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden United Kingdom Average CE-8: Czech Republic Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia Average

Infant mortality2

Adult literacy

School enrolment3

Telephone lines4

Internet hosts4

CO2 emission6

Poverty7

HDI value8

HDI rank9

176 286 030 366 392 690 854 011 535 755 993 616 497 138

0.4 0.6 0.5 0.5 0.4 n.a. 1.5 0.8 0.5 n.a. 0.6 0.9 0.7 0.3

n.a. n.a. n.a. 4.8 9.9 7.3 n.a. n.a. n.a. 0.3 7.1 n.a. n.a. 6.3

0.926 0.939 0.926 0.93 0.928 0.925 0.867 0.885 0.913 0.925 0.935 0.88 0.913 0.941

15 4 14 10 12 17 24 18 20 16 8 28 21 2

Electricity use5

78.1 78.4 76.2 77.6 78.6 77.7 78.2 76.6 78.5 77.4 78.1 75.7 78.5 79.7

5 6 4 4 4 5 5 6 5 5 5 6 5 3

99 99 99 99 99 99 97 99 98 99 99 92 98 99

90 100 97 100 94 94 81 91 84 72 100 96 95 100

467 498 720 550 579 611 532 420 474 750 618 430 421 682

59.0 29.4 62.9 102.3 19.1 24.8 10.5 29.7 17.8 27.1 101.9 6.2 11.3 67.3

77.7 77.6

6 4.9

99 98.3

100 92.9

589 556

28.2 39.8

5 384 7 048

0.8 0.6

15.7 7.3

0.928 0.917

13

74.9 70.6 71.3 70.4 72.1 73.3 73.3 75.5 72.7

5 17 8 17 17 9 8 5 10.7

70 86 81 82 80 84 76 83 80.2

378 363 372 303 321 282 314 386 340

15.4 28.4 10.4 10.7 4.8 8.8 7.0 11.0 12.1

4 3 2 1 1 2 4 5 3

4.4 4.9 2.5 2.6 3.1 6.0 2.5 n.a. 4.6

1.010 18.0 2.010 28.0 17.0 10.0 8.0 1.010 10.6

0.849 0.826 0.835 0.800 0.808 0.833 0.835 0.879 0.833

33 42 35 53 49 37 36 29

99 99 99 99 99 99 99 99 99

6 7 6 14 6 5 3 5 4 12 5 3 4 14

280

Table 11.2 Selected economic and human development indicators, EU and CEE countries, 1997

682 435 874 851 769 309 216 218 294

CE-7: Albania BosniaHerzegovina Bulgaria Croatia Macedonia (FYR) Romania Yugoslavia Average CIS-4: Belarus Moldova Russia Ukraine Average

73.2

27

84.7

71

39

0.1

1 801

1.8

n.a.

n.a. 70.8 73.8

n.a. 15 8

n.a. 98.4 98.3

73.1 69.8 n.a. 72.1

22 19 n.a. 18.2

68.5 66.6 66.1 68.1 67.1

17 27 18 17 19.75

0.733

92

n.a. 72 68

n.a. 350 365

n.a. 2.2 3.7

n.a. 2 899 2 674

n.a. 2.4 n.a.

n.a. 22 n.a.

n.a. n.a. 0.779 62 0.809 48

94.0 98.1 n.a. 94.7

70 69 n.a. 70

255 175 n.a. 237

0.8 1.9 n.a. 1.7

298510 1 511 n.a. 2 374

n.a. 4.5 n.a. 2.7

n.a. 23 n.a. 22.5

0.772 0.752 n.a. 0.769

99.0 98.9 99.0 99.0 99.0

77 72 78 77 76

269 133 218 206 206

0.2 0.4 2.2 0.7 0.9

2 704 581 4 050 2 306 2 410

4.1 n.a. 5.5 6.9 5.7

2310 82 53 25 45.7

0.788 56 0.701 105 0.781 60 0.748 80 0.755 n.a.

65 63 n.a. n.a.

Notes 1. In years from birth. 2. Per 1000 births, 2000. 3. Combined gross enrolment in primary and secondary schools in per cent, 100 per cent assumed for values exceeding 100 (1999). 4. Per 1000 people, 2000. 5. kWh per capita. 6. In Kg per 1$ of GDP, 1996. 7. Percentage of population below the poverty line: $11 per capita per day (1994 PPP $) for EU countries (1994–95), $4 per capita per day (1990 PPP $) for CEECs and CIS (1996–99). 8. The human development index is a synthetic measure of eight socioeconomic variables. For its definition see UNDP (1998). 9. Ranking of all countries covered by the UN Human Development Report. 10. 1995. Source: UNDP (2002).

281

282 The Impact of EU Enlargement on Economic Disparities

The statistics on the number of telephone lines per 1000 inhabitants show the inadequacy of the communication infrastructure in the CEECs. The average number of lines in the CEECs is 60 per cent below that for the EU-15, and for some countries the difference is much bigger (Albania, Romania and Poland). The next indicator – electricity consumption per capita, which can be seen as a measure of general development – reveals a gap of some 50 per cent between the EU-15 and the CEECs. Finally, the average CO2 emission level in the CE-8 and CIS-4 is seven to nine times higher than in the EU-15 (chiefly because of the very high pollution levels in Poland and the CIS countries); other CEECs have somewhat lower emission levels, but even these are at least four times higher than those in the EU. Clearly the improved environmental protection needed in the CEECs to meet the EU standards will require massive expenditure for many years to come. All eight indicators discussed so far show the magnitude of the development gap between the EU countries and the CEECs, measured in terms of accumulated ‘wealth’ assets such as human capital, health care, environmental protection and communication infrastructure. In most cases these indicators confirm the picture obtained from the per capita GDP figures: not only are the current income levels inferior in the CEECs but also the level of accumulated wealth is much lower than in the EU countries. The disparities between more advanced (CE-8) and less advanced transition (CE-7) countries are less marked, although in some areas the CE-8 seem to be advancing more quickly (for example in terms of Internet connections). There is also much more variability across the CEECs than across the EU. There are two more indicators in Table 11.2. First, the percentage of people living below the poverty line is a measure of the level of both general economic development and income distribution. It shows that even in countries with relatively high levels of per capita GDP, such as Ireland and Spain, a substantial proportion of the population live in relative or absolute poverty4. Poverty seems to be particularly widespread in the Baltic states and the CIS countries. This indicator also conveys another, more ominous message: it shows the scope for social conflict arising from the unequal distribution of income and general poverty. It can be assumed that countries with a high proportion of the population living under the poverty line are generally less politically stable than other countries, and the danger of instability is greater when poverty lines coincide with ethnic and cultural borders within individual states (Yugoslavia, Bosnia and Macedonia). Second, the human development index (HDI), constructed as a linear combination of several economic and social indicators, broadly confirms the earlier observations. The CEECs lag far behind the EU countries in terms of income levels and other indicators of economic and human development; and the differences within the CEEC group are larger than those within the EU but are less pronounced than those between the CEECs and

Dariusz K. Rosati 283

the EU. This suggests that the main dividing line in Europe is still between Western Europe and the CEECs, with lesser divisions between the CEECs themselves. What are the causes of these development gaps? The economic and cultural damage inflicted by 50 years of communist rule cannot explain the disparities within the CEEC group, and the CEECs were much poorer than the Western countries even before the Second World War. One interesting observation is that countries located farther east and south from the EU tend to be economically less developed and their performance in the transition period has been poorer. Therefore the gap seems to increase in line with the distance between a given country and the core of the EU. Figure 11.1 plots per capita GDP against the distance by road from 32 capital cities to Brussels. There is a clear correlation: the longer the distance the lower the per capita GDP for a given country. The estimated regression equation shows a relatively strong and statistically significant relationship between the two variables. Is there any economic sense in this result, and how should it be interpreted? Obviously, kilometres or miles do not directly translate into GDP figures. But the distance may affect intensity of trade and, more broadly, economic and cultural contacts between countries. In this exercise Brussels is not just the symbolic capital of Europe, but a central point of a region that for several centuries has recorded high rates of economic growth and is now economically most developed, with the highest levels of per capita income and established market institutions. With some arbitrariness, the region broadly covers the rectangle London–Amsterdam–Frankfurt–Paris, with Brussels at the centre.5 Distance counts not only for trade (through transport and other transaction

3000 y = –0.0432x + 2097.9 R 2 = 0.4553

2500

Distance (km)

2000 1500 1000 500 0 –500 10 000

20 000 30 000 40 000 Per capita GDP (PPP $)

50 000

Figure 11.1 Relationship between the distance from Brussels and per capita GDP for 32 European countries (EU-15 and 17 CEECs), 2000

284 The Impact of EU Enlargement on Economic Disparities

costs) but also, and more importantly, for the dissemination of technological and other advances, including advances in market and state institutions. The greater the distance the less contact there is between different peoples and the more difficult and weaker the process of dissemination. The results obtained therefore suggest that the per capita GDP differentials are deeply rooted in the different historical and cultural experiences of individual countries and their long-term relations with the most advanced region of Europe. These differences are also reflected in institutional arrangements in individual CEECs. Possession of the necessary institutional infrastructure for a market economy is an essential element of a country’s social capital and a precondition for successful catching up. The more advanced CEECs already had some rudimentary market institutions under communism, either as a result of earlier reforms (Hungary and Poland) or simply as certain attitudes and habits inherited from the capitalist past (the Czech Republic and the Baltic countries). This is one of the main reasons for their generally better economic performance during the transition process (see for example de Melo et al., 1996). Market institutions were much weaker or even nonexistent in other CEECs, especially in the Balkan and CIS countries. The role of institutions in economic development has been the subject of systematic research since at least the time of Veblen and Schumpeter, but in the context of economic transformation the problem has yet to be fully grasped.6 Even less attention has been paid to the role of institutional characteristics in explaining economic disparities and conditions for convergence. One of the few attempts to measure the impact of this resulted in the methodology proposed by Adelman and Morris (1967), which was later developed by Temple and Johnson (1998).7 In the early 1990s the European Bank for Reconstruction and Development (EBRD) developed a set of indicators of institutional development that can be combined into one synthetic measure of progress in institutional reforms (EBRD, 1998, pp. 25–7). The EBRD’s approach is specifically geared to assessing the process of transition, but it is limited to selected areas of reform and is largely based on subjective judgements. One simple way of assessing the degree of institutional progress in building a market system is to look at whether a country has gained membership of international economic organizations such as the EU, the OECD or GATT/WTO. In Table 11.3, five membership criteria have been used to rank CEECs according to membership status organizations (one point for membership, zero for non-membership). This ranking broadly parallels the ranking by the EBRD index, as well as the ranking by distance from Brussels. The values of the two indices and the distance from Brussels, plotted in Figures 11.2 and 11.3 respectively, clearly show an inverse relationship. These observations suggest that the greater the distance between Western Europe and the countries in question the less developed the market institutions needed for successful economic development.

285 Table 11.3 Progress of institutional reforms in the CEE countries by membership of international organizations as of June 2002 Europe IMF Total OECD EU first WTO Agreement Article membership EBRD membership group membership with EU VIII index index1 Czech Republic Hungary Poland Slovakia Slovenia Estonia Latvia Lithuania Bulgaria Romania Croatia Moldova Albania Macedonia Russia Belarus Ukraine BosniaHerzegovina Yugoslavia

1 1 1 1 0 0 0 0 0 0 0 0 0 0 0 0 0

1 1 1 1 1 1 1 1 0 0 0 0 0 0 0 0 0

1 1 1 1 1 1 1 1 1 1 1 1 1 0 0 0 0

1 1 1 1 1 1 1 1 1 1 0 0 0 0 0 0 0

1 1 1 1 1 1 1 1 1 1 1 1 0 1 1 1 1

5 5 5 5 4 4 4 4 3 3 2 2 1 1 1 1 1

3.62 3.79 3.61 3.45 3.37 3.62 3.37 3.46 3.14 2.96 3.30 2.80 2.69 2.87 2.77 1.75 2.66

0 0

0 0

0 0

0 0

0 0

0 0

2.25 n.a.

Note 1. The index values are calculated as a simple average of eight transition indicators. Source: EBRD, 2002.

6

Index value

5 4 3 2 1 0 500

y = –0.0025x + 7.3407 R 2 = 0.42

1000

1500

2000

2500

Distance (km) Figure 11.2 Membership index and distance from Brussels of 17 CEECs, 2002

286 The Impact of EU Enlargement on Economic Disparities 4.0 3.5 EBOR index

3.0 2.5 2.0 1.5 1.0 0.5 0 500

y = –0.0006x + 4.2053 R 2 = 0.2693 1000

1500 2000 Distance (km)

2500

3000

Figure 11.3 EBRD index of institutional reforms and distance from Brussels of 17 CEECs, 2002

Economic disparities: the dynamic perspective The current economic and social differentials in Europe may change over time, depending on the relative growth rates. According to neoclassical growth theory, poorer countries tend to grow faster than richer countries because of diminishing returns to capital. This hypothesis, however, does not seem to be supported by the available evidence for the CEECs. While statistical data on GDP changes show that in recent years economic growth has been much faster in the more advanced CEECs than in the EU, economic growth in the other CEECs has been much slower, and in many cases negative. Hence the distance has narrowed between the EU and the more advanced CEECs but widened between the more advanced and less advanced CEECs. It is believed that this tendency will be strengthened by the accession of the more advanced CEECs to the EU. One important question that arises in this context is whether this trend will be permanent and lead to a new rich country/poor country division on the continent. It will be shown below that this is not just a theoretical possibility. Table 11.4 shows growth performance of the EU-15 and the CEECs during the period 1992–2000 (that is, since the ‘transformational recession’8 that ended in 1992 in most CEECs). Only in the CE-8 was the GDP growth rate higher than in the EU-15 – by 0.17 percentage points, which was not a particularly impressive performance given the magnitude of the initial difference between the two groups. In the CE-7 economic growth was slower and in the CIS-4 it was negative. The averages for the country groups mask substantial differences between the performance of individual countries. The GDP of the best-performing CE-8 country, Poland, grew at the average annual rate of 5.3 per cent, while Lithuania registered a negative growth rate of 1 per cent. Similarly the fastest growing CE-7 economy was Albania (6.9 per cent), while the Yugoslav

Dariusz K. Rosati 287 Table 11.4 Growth performance of the EU and CEE countries (per cent per annum, average 1992–2000) GDP growth rate EU-15 CE-8 CE-7 CIS-4

2.27 2.44 1.22 ⫺4.20

Source: Calculated from UN ECE (2002).

economy shrank by 3.6 per cent per annum (statistics for Bosnia-Herzegovina are not available). All the CIS-4 countries registered negative growth rates, ranging from ⫺0.3 per cent (Belarus) to ⫺7.7 per cent (Ukraine). The differing growth performance among the CEECs can be explained by a number of factors. The historically earliest explanation is the uneven progress of market reforms and differences between the economic policies pursued by individual countries. The fastest growing countries were generally those which made radical and comprehensive reforms at the outset of the process, including macroeconomic stabilization, microeconomic liberalization and privatization. In other countries the reforms were either slow or piecemeal – in some countries macroeconomic restrictions were not accompanied by necessary structural reforms (Bulgaria and Latvia), in others stabilization was limited to monetary tightening (Russia and Moldova), and in yet others elementary macroeconomic discipline was missing altogether (Romania and Albania). The political environment for reforms has also differed among countries. Economic performance has generally been much worse in countries that have gone through extensive periods of civil unrest or war, most frequently connected with ethnic conflicts or the violent disintegration of former federal states. Countries such as Yugoslavia, Bosnia-Herzegovina and Moldova lost years of economic growth because of internal instability and civil war and it remains to be seen whether the recently achieved stability in some of these countries will provide a solid foundation for future economic growth. A number of studies have emphasized the part played by initial conditions, including the institutional environment for reforms and transition policies (for example De Melo et al., 1996; Fischer et al., 1998; Havrylyshyn and Wolf, 1999). These studies demonstrate that countries with a previous history of capitalism (the Czech Republic and the Baltic states) and/or early reform attempts (Hungary, Poland and Slovenia) were generally able quickly to overcome the initial recession and embark on a sustainable growth path. These findings are consistent with our earlier observation that geographical location can explain the speed and scope of the dissemination of capitalist and free market institutions in the CEECs. It should be noted that the

288 The Impact of EU Enlargement on Economic Disparities

importance of the first two factors (the speed and scope of reforms, and the political environment) in explaining the differing performance of individual CEECs has diminished over time. With hindsight it can be concluded that the part played by institutions in a broad sense, including the rule of law and social capital, has probably been the most important determinant. If this is correct, it gives clear guidance to policymakers in CEECs as to what should be done to complete the transformation of their economies and ensure stable growth. It shows that a successful transition does not result from ‘shock therapy’ or macroeconomic stabilization, but is the result of a long process of consistent institution building. Implications for stability and security Large disparities between economic standards could become a source of social and political instability if poor countries have no realistic prospect of catching up with living standards elsewhere, especially as the demonstration effect from affluent countries is strong due to the free flow of information and relatively open borders. The usual reaction to depressed living standards is to put pressure on the national government to improve the situation or to step down. This can lead to social unrest and political struggle, which may not always be channelled through democratic procedures. Political instability translates into frequent changes of government, and in the longer term leads to the erosion of public support for state and democratic institutions. At a later stage, if no improvement has taken place, the public and the government tend to externalize domestic problems: this can take the form of increased migration abroad and/or the deterioration of relations with neighbouring countries. Instability may thus be exported to other countries. The potential for instability can be inferred from economic data. Very slow growth (or protracted recession) that leads to a widening of the gap in living standards between poor and rich countries should be of special concern. Two other key economic variables to be monitored in this context are unemployment and poverty. Unemployment rates are generally higher in the less advanced transition countries, and the very high rates in some countries (Macedonia, Yugoslavia and Albania) could be one of the causes of continued social instability. These figures generally confirm the picture obtained from the data on the percentage of people living below the poverty line (see Table 11.2). Unemployment and poverty in combination can be a highly destructive force. High growth rates, on the other hand, can mitigate social tensions by offering the prospect of a better future. The three indicators can therefore be combined into one synthetic measure of the potential for instability – the PIN index. With some arbitrariness the figures (in percentage points) for unemployment, proportion of the population below the poverty line and average GDP growth for three years (1997–2000) have been given weights of 0.25, 0.25 and 0.5 respectively.9 The results are presented in Table 11.5, which

Dariusz K. Rosati 289 Table 11.5 Potential for instability in the CEE countries according to the PIN index value,1 2000

Hungary Slovenia Czech Republic Belarus Poland Estonia Slovakia Russia Lithuania Latvia Croatia Bulgaria Romania Albania Ukraine Yugoslavia Macedonia Moldova

Ranking

PIN index value

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

0.325 0.950 2.050 3.375 4.125 4.475 5.250 5.200 6.600 7.000 7.700 8.025 9.075 12.925 13.250 15.900 19.175 24.250

Note 1. See endnote 9 for an explanation.

ranks the CEECs from the lowest to the highest risk of instability. This ranking corresponds quite well to intuition. As expected the CE-8 rank well, while most of the Balkan countries and some CIS states show very high levels of potential instability (the surprisingly high ranking for Belarus can be partially attributed to very imperfect statistics on growth and unemployment). The potential for instability can be permanently reduced only by sustained, rapid and equitable economic growth, which offers the prospect of a systematic increase of incomes and more job opportunities. These positive prospects can be enhanced by international assistance programmes, including those related to accession to a ‘club’ of richer countries. This is now the case with the group of more advanced CEECs as a result of their high growth rates and prospective membership of the EU. By contrast there are no such prospects for the rest of the CEECs. Catching up With the elimination of political and ideological differences the key to continent-wide stability and security lies in sustained economic development, and specifically in the CEECs securing high rates of economic growth. Only then can they catch up with Western Europe in terms of income and welfare.

290 The Impact of EU Enlargement on Economic Disparities

CEECs that wish to join the EU as full members will also have to converge with the EU countries in terms of structural and macroeconomic characteristics. Hence the catching-up process will have to advance on two tracks: income (or real) convergence and policy (or nominal) convergence. Nominal convergence is important for those CEECs that are to join the EU as full members in 2004. As stipulated in the Maastricht Treaty, these countries will also have to join the Economic and Monetary Union (EMU). The Maastricht criteria for nominal convergence refer to inflation, longterm interest rates, the government budget deficit, gross government debt and exchange rates.10 Given that interest rates and exchange rates are essentially functions of inflation levels, assessment of the CEECs’ distance from the Maastricht standards can be based on three variables only: inflation, the budget deficit to GDP ratio and the public debt to GDP ratio. Data on inflation and budget deficits are presented in Table 11.6. Most of the CE-8 countries are not far from meeting the Maastricht criteria on both fronts, though considerable fiscal tightening will be necessary in the Czech Republic and Poland, and strong disinflation is required in Hungary, Slovakia and Slovenia. The data confirm that the CE-8 have been making an effort to converge with the EU countries in terms of nominal macroeconomic variables, and that the criteria can be met by the time of accession to EMU. This policy trend has recently come under criticism (see for example Andreff, 1999).11 It is argued that restrictive monetary and fiscal policies may actually hamper economic growth in the CEECs and delay their catching up, and that they should generally follow growth-oriented policies. Indeed as inflation tends to be permanently higher in catching-up countries because of the presence of the Balassa–Samuelson effect, keeping inflation within the reference level will require more restrictive monetary policies and higher interest rates. This could in turn reduce investment, slow down growth and eventually bring the catching-up process to a halt. Let us now have a closer look at income (or real) convergence. The literature on economic growth indicates that once the transition period is over and all the necessary reforms are implemented, long-term growth is driven by long-term trends in capital and human capital accumulation, technological progress and population growth. In addition neoclassical theory tells us that low-income countries will generally grow faster than mature economies because, with low ratios of capital to labour, they have higher marginal products of capital (Barro, 1991; Barro and Sala-i-Martin, 1992; Romer, 1996). The key question in this context is whether the CEECs can indeed grow fast enough to converge with the per capita income levels in the EU. Various models have been used to project long-term economic growth. To assess the long-term growth potential of the CEECs, Fischer et al. (1998) have applied two equations that have be estimated for a large cross-section

Dariusz K. Rosati 291 Table 11.6 Inflation and budget deficits in Central and Eastern Europe, 2001

CE-8: Czech Republic Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia CE-7: Albania Bosnia-Herzegovina Bulgaria Croatia Macedonia Romania Yugoslavia CIS-4: Belarus Moldova Russia Ukraine Euro area Maastricht criterion level

General government deficit (% of GDP)

Inflation (CPI, % per annum)

6.0 0.5 4.0 4.3 1.5 5.5 4.5 1.3

4.7 5.8 9.2 2.4 1.5 5.5 7.3 8.6

9.1 1.7 5.2 6.0 3.5 2.4

3.1 1.8 7.3 5.0 5.2 34.5 90.4

1.4 2.6 ⫺2.9 1.7

61.4 9.8 21.6 12.0

n.a. 3.0

2.7 3.71

Note 1. Average inflation level in three euro-zone countries with lowest inflation plus 1.5 percentage points. Source: UN ECE (2002).

sample of countries: one by Barro (1991) and the other by Levine and Renelt (1992). Denoting per capita GDP growth as y, the Barro growth equation is y ⫽ 0.0302 ⫺ 0.0075Y(1960) ⫹ 0.025 PRIM ⫹ 0.0305 SEC ⫺ 0.119 GOV

(11.1)

and the Levine–Renelt growth equation is y ⫽ ⫺0.83 ⫺ 0.35Y(1960) ⫺ 0.38 POP ⫹ 3.17 SEC ⫹ 17.5 INV

(11.2)

where Y(1960) is the initial level of real per capita income on a PPP basis (expressed in logarithms in the Barro equation and in thousands of US dollars

292 The Impact of EU Enlargement on Economic Disparities

in the Levine – Renelt equation), POP is the population growth rate, PRIM is the gross primary school enrolment rate, SEC is the secondary school enrolment rate, GOV is the share of government consumption expenditure in GDP, and INV is the share of investment in GDP (all the coefficients except POP and the constant term in Equation 11.2 are significant at the 5 per cent level). Fischer et al. (1998) assumed a uniform investment to GDP ratio for all CEECs (30 per cent) and a uniform government consumption to GDP ratio (10 per cent), and then calculated the average per capita growth rates for the CEECs. These growth rates were used to calculate the number of years needed for the CEECs to converge with the per capita GDP levels of lowincome EU countries (the average for Greece, Portugal and Spain). At first glance the results obtained by Fischer et al. seem to provide a fairly reasonable estimate of the catching-up period for the whole CEEC group. The estimated growth rate differentials of 3–4 per cent per annum imply a catchingup period of 10–25 years for the CE-8 countries (except Lithuania) and 30–70 years for the other CEECs. There are, however, certain problems with these equations. First, the per capita GDP figures expressed in PPP dollars and used in the calculations are in some cases very different from those reported elsewhere (for example those for Estonia, Albania, Macedonia and Slovenia). Second, the differences between the obtained growth rates for individual countries are very small, which is partly the result of fairly similar ratios of primary and secondary school enrolment across the CEECs and partly the result of an unrealistic assumption about the uniformity of the economic policies followed by the CEECs. The assumed values of the investment ratio (30 per cent of GDP) and the government consumption ratio (10 per cent of GDP) are not only quite different from the empirical data, but also do not reflect differences in investment ratios arising from different levels of FDI inflows. According to World Bank data the CEECs’ investment ratios range between 17 per cent and 28 per cent, and they never reach 30 per cent. Furthermore the ratio of government consumption to GDP in all CEECs is higher than that assumed by Fischer et al. Had these more realistic figures been used the estimated growth rates would have been lower. Finally, the structural parameters were estimated with a different set of initial per capita GDP figures, much lower than those observed at present, which could have led to a systematic error when estimating the CEEC growth rates. These problems suggest that both models need revision in order to account properly for specific characteristics of these countries. An alternative approach is to estimate the speed of convergence of CEEC income levels towards EU income levels on the basis of the observed differences between the growth paths. The standard equation used in this context is as follows (see Barro and Sala-i-Martin, 1992; Romer, 1996): ln [y(t)/y(0)] ⫽ [1 ⫺ exp(⫺␭t)] ln y* ⫺ [1 ⫺ exp(⫺␭t)] ln y(0)

(11.3)

where y(0) is the initial level of per capital GDP, y(t) is the level of per capita GDP in period t, y* is the steady state level towards which the values of y

Dariusz K. Rosati 293

converge, and ␭ is the speed of convergence towards the steady state. Equation 11.3 shows that the GDP growth rate depends inversely on the initial level y(0) – the assumption that reflects the neoclassical postulate that poor countries tend to grow faster than rich countries. Rearranging terms gives ln y(t) ⫽ [1 ⫺ exp(⫺␭t)] ln y* ⫹ exp(⫺␭t) ln y(0)(5)

(11.4)

Denoting [1 ⫺ exp(⫺␭t)] ln y* ⫽ a, exp(⫺␭t) ⫽ b, and adding the disturbance term ε(t), Equation 11.4 can be rewritten as ln y(t) ⫽ a ⫹ b ln y(0) ⫹ ε (t)

(11.5)

We have tested Equation 11.5 for a cross-section of 14 EU countries (without Luxembourg) and 10 CEECs (the CE-8 plus Bulgaria and Romania) for the period 1992–97. In the first iteration the current dollar values of per capita GDP in 1992 were taken as y(0) values, and y(t) values were simulated by applying the registered per capita GDP growth rates between 1992 and 1997 to obtain hypothetical per capita GDP values for 1997. The estimation yielded the following results (t-statistics in brackets): ln y(t) ⫽ ⫺0.017 ⫹ 1.024 ln y(0) (⫺0.096) (52.77) R2 ⫽ 0.9922; F-statistic ⫽ 2784.6; SE(y) ⫽ 0.131 For b ⫽ 1.024, ␭ ⫽ ⫺0.0042, which means that for the 24 countries in the sample convergence was negative and the distance between rich and poor countries actually increased by 0.4 per cent per annum. The lack of positive convergence can be partly explained by significant falls in output in less advanced CEECs in the first half of the 1990s. In a more general sense, however, it casts doubts on the validity of the convergence hypothesis.12 To check whether there was a positive convergence between the more advanced CEECs and the EU, the two less advanced CEECs (Bulgaria and Romania) were dropped from the sample and Equation 11.5 was re-estimated for a sample of 22 countries, including the EU-14 and CE-8. The results were as follows: ln y(t) ⫽ 0.117 ⫹ 1.010 ln y(0) (0.606) (47.44) R2 ⫽ 0.9912; F-statistic ⫽ 2252.8; SE(y) ⫽ 0.130 For b ⫽ 1.010, ␭ ⫽ 0.0012, which means that for the 22 countries in the sample convergence was still negative and the distance between the rich and poor countries increased by about 0.1 per cent per annum. Both results suggest that on average no convergence took place, but that obviously does not mean there was no convergence by individual countries. The above results convey a rather pessimistic message. First, there is nothing automatic in the neoclassical convergence hypothesis that will necessarily yield a positive convergence. Second, unless the CEECs’ growth rates

294 The Impact of EU Enlargement on Economic Disparities

become significantly higher than those registered in 1992–2000 it will take them many decades to reach income levels that are close to those in the EU.

EU enlargement and its impact on economic disparities among the CEECs Eastern enlargement In 2002 the process of European integration entered a new stage. After several years of preparations and discussions, and conforming to earlier political decisions, the EU completed the membership negotiations with the CE-8 and fixed the date of formal accession at 1 May 2004. Thus the long awaited eastward enlargement will soon become a reality. The historic significance of this fact cannot be disputed. For the first time in its 45-year history the EU is reaching beyond the traditional boundaries of Western Europe to embrace countries in Central and Eastern Europe that were under Soviet domination from the end of the Second World War until 1989. Together with NATO enlargement, the eastward enlargement of the EU is a decisive step towards eliminating the remnants of the postwar division of the continent and establishing a much broader basis for economic and political cooperation among European nations. However not all doubts have been dispelled or problems solved. First, the successful completion of the enlargement process still depends on political decisions to be taken by the parliaments of the EU and candidate countries. A massive and intelligent information campaign on both sides is needed to secure political support at the ratification stage. Second, while the first group of invited CEECs now has a clear prospect of accession, the other CEECs still face uncertainty about their future place in Europe. This may lead to a new division in Europe between the enlarged EU and the ‘left-outs’. These two issues will be discussed below. Benefits and costs of eastward enlargement The decision to expand the EU was motivated by the important political and economic benefits that would be gained from enlargement. These benefits were expected to accrue both to the new member countries and to the incumbent members. However, with a few exceptions, the early literature on EU enlargement mostly concentrated on the costs of enlargement, particularly for the EU countries (see for example Courchène et al., 1993; Baldwin, 1994). Recently this imbalance in the literature has been rectified, with many new studies demonstrating that the benefits of EU enlargement will largely exceed the costs (Baldwin et al., 1997; Breuss, 2001). This is a welcome development because the issue of enlargement costs has clearly affected the attitude of EU countries towards enlargement, with scepticism and doubt becoming more prevalent. It is also important in the context of the main theme of this chapter, because the large (net) benefits gained by the new

Dariusz K. Rosati 295

members after accession will improve their relative position vis-à-vis nonmember countries. This is likely to widen even further the gap between the more advanced and less advanced CEECs. Political benefits The political reasons for enlargement stem from the fact that the EU – and indeed the entire idea of European integration – has always been a politically motivated project. The political benefits of economic integration, including eastward expansion, can be classified into four categories: international security, internal stability, support for democracy and reforms, and geostrategic advantages. With regard to the first of these categories, it is believed that close economic and political cooperation between nations, firms and individuals will work in favour of security and peace. Economic integration will speed up economic development and help to reduce the disparities in wealth and income that could lead to international conflict. By establishing international networks of production and trade contacts that bring benefits to all involved, integration will help to develop broad popular support for international cooperation and open borders, thus reducing the potential and scope for alternative ways of protecting national interests, such as aggression and armed conflict. The security aspect is particularly important in the case of Central and Eastern Europe, where state borders have changed frequently in the past and long-established ethnic and national hostilities still exist. Both historical experience and logic clearly suggest that Western Europe cannot be fully secure until peace is firmly established throughout the European continent. The second expected benefit of integration is internal stability in the CEECs. This will be achieved not only through the adoption by the CEECs of West European rule of law concepts and democratic institutions, but also through the prospect of faster welfare growth for all social groups. This is particularly important in the case of countries where social discontent caused by poor living standards inherited from the communist era could lead to persistent instability. One of the dangers to internal stability in the early stage of transition was social frustration caused by the collapse of the egalitarian welfare state and the rapidly growing differences in incomes and wealth. This frustration may have been strengthened by the gap in living standards between the transition economies and their western neighbours. The rapid improvement in the material well-being offered by integration is thus essential to domestic social and political stability. The third expected benefit is that accession to the EU will strengthen the CEECs’ reform policies and buttress democracy. Populism, nationalism and authoritarian tendencies can be held in check if a country is a member of international organizations and therefore has to conform to internationally agreed standards and norms of democracy and the rule of law. On the

296 The Impact of EU Enlargement on Economic Disparities

foreign policy front, commitment to democracy is important, given that the newly re-established independence of the former Soviet satellite countries might open up old territorial disputes and revive old ethnic animosities. Clearly democracy prefers to live in peace, so extending West European institutions to Eastern Europe is seen as a safeguard of stability and predictability. Finally, Central and Eastern Europe constitute a region of considerable strategic importance, located as it is between the EU and Euro-Asiatic Russia. Unless its geopolitical status is clearly established it might eventually become a region that is contested politically and economically by external powers – an arena ripe for conflicts. However if it becomes an integral and undisputed part of the expanding EU it will play a very constructive role as a bridge between Europe, Russia and the other CIS countries. The ‘conflict arena versus bridge’ dichotomy is an important factor in the pro-European stance of CEEC foreign policies. Political benefits, as vital as they certainly are, are very difficult to measure in pecuniary terms. For example how could one estimate the value of non-realized conflicts? This is probably one of the reasons why they have been given insufficient attention in routine discussions on the costs and benefits of EU enlargement, and have typically been given only lip service in political statements and declarations. Much more attention has been paid to more prosaic and immediate considerations, such as budgetary costs and migration pressures. The political benefits seem so obvious, natural and uncontroversial that they do not appear to require any further attention. In fact they are treated as though they are already in place and irreversible, and thus require no further effort. To accept such a position would amount to dangerous and unjustified complacency. There is no reason to assume that the current state of affairs will last forever, so it must be solidly buttressed by long-term institutional and political arrangements. The EU and NATO enlargements provide for such an arrangement, which is why political considerations provide crucial arguments in favour of enlargement and must not be ignored or belittled. Economic benefits Economic theory arguments for eastward enlargement are now well established (Baldwin, 1994; Molle, 1994; Baldwin and Venables, 1995). Integration will mean the elimination of barriers to trade and factor movements, as well as the unification of institutional arrangements, eventually leading to the creation of an integrated economic system. As a general proposition the theory of economic integration states that expanding markets and removing barriers to trade and resource flows increases economic efficiency, in both the static and the dynamic sense, and contributes to economic growth. The theory also tells us that static benefits arise from the expansion of trade, better allocation of resources and reduction of transaction costs, while the dynamic

Dariusz K. Rosati 297

benefits arise from efficiency gains produced by more competition, more investment and economies of scale. The dynamic benefits are considered to be much larger than the static benefits, but they are also more difficult to measure. When considering the effects of free trade in goods it should be noted that the EU is not a free trade arrangement; it is a customs union. An important implication is that establishing a customs union – in contrast to a free trade area – implies the adoption of a common external tariff. This can lead to welfare losses in one or several member countries if their initial situation is one of free trade rather than protectionism. This is, however, a rather remote possibility in the context of EU expansion because the bulk of trade between the CEECs and the EU is in manufactures, for which the applicant CEECs have generally had higher levels of tariff protection (except Estonia and the Czech Republic) than applied by the EU-15. The average MFN tariff in the EU is now about 3 per cent, while in the applicant CEECs it is between 5 per cent and 7 per cent for most industrial goods, with much higher tariff differentials for goods such as transport equipment, machinery and wood products (Kawecka-Wyrzykowska and Rosati, 2002). Only in agro-food products and fish is the EU’s MFN tariff higher than that of CEECs (16 per cent versus 2 per cent for the former and 8 per cent versus 11 per cent for the latter). The adoption of a common tariff will therefore lead to the expansion of industrial imports by CEECs and some reductioncum-diversion of imports of agro-food products. This could entail some additional costs in terms of higher domestic prices and may require compensation to be paid to non-EU exporters (mainly the United States) under the GATT/WTO rules. Static effects are insufficient to make a comprehensive assessment of customs unions. Firms, people and governments do not sit idle, but try to adjust to changing circumstances. One of the most important long-term benefits of customs unions is the positive impact of increased competitive pressure on technical efficiency: when firms are confronted with extra foreign competition that cannot be contained by political action they reduce costs, apply new technologies, rationalize employment and step up their marketing efforts. In the long term these adjustments shift the national aggregate supply curve downwards, producing efficiency gains. The problem with these gains is that they are very difficult to measure. One possibility is to investigate changes in unit production costs; but these would also reflect economies of scale and many other factors. This is probably one of the reasons why empirical research studies on the efficiency gains arising from customs unions rarely produce conclusive results. The second important long-term benefit is the economies of scale that arise from the expansion of sales to a larger market. These are easier to capture than the more elusive efficiency gains and, given some assumptions, can be measured by changes in unit production costs, which are typically

298 The Impact of EU Enlargement on Economic Disparities

calculated on a sectoral basis. But certain benefits are internal to the firm – including effects on the firm’s growth and of the learning-by-doing process – and these are rather difficult to measure directly. International production networking is a popular strategy among multinational firms for lowering costs and improving competitiveness (Zysman and Schwartz, 1998). As in the previous cases, the economic gains from networking may be reflected in a fall of unit production costs, but unless special decomposition techniques are used it is very difficult to attribute an observed change in production costs to a specific set of factors. In general the long-term effects of customs unions are almost certain to be positive, and they are seen as much more important than the short-term effects. The gains from the free flow of resources, including capital and labour, can be substantial. The new EU members are certain to attract inflows of capital, particularly in the form of FDI. Such inflows have already been substantial for some of the more advanced transition countries, and they can be expected to increase once the CEECs in question become full members. This is because integration will expand the size of the market, replacing separate national markets by a giant regional one. Moreover the reduced investment risk (due to political and economic integration) and institutional-cum-policy convergence will lead to lower transaction costs in member countries, which will in turn result in higher rates of return. Why will EU enlargement affect FDI flows into the accession countries? The first effect will be a reduction of the perceived political risk of investing in these countries. The risk of such events as political instability, nationalization, conflict with neighbours or external aggression is an important consideration for foreign investors.13 The fact that the CE-8 have attracted much more FDI than other CEECs suggests not only that the market has assigned lower risk levels to the CE-8, but also that it has probably anticipated their absorption into the EU and that the effect of membership on political risk has already been partly absorbed. The significance of political risk has recently been confirmed by events in Romania, where the change of government in late 1996 and the adoption of much more reform- and European-oriented policies (including faster privatization) probably contributed to the massive fivefold jump in FDI in 1997. The second impact of EU enlargement will be the reduced cost of FDI in CEECs due to the harmonization of laws and the convergence of structural and economic policies. The cost to a multinational corporation of establishing a foreign enterprise will be lower if the regulatory framework in the target country is the same as in the home country, including product standards, rules of contract enforcement, guarantees and dispute settlement mechanisms. Such an environment will be seen as friendly and as requiring less effort to start production. This benefit will be particularly important for FDI originating in the EU countries. The harmonization of laws and policy convergence will also substantially reduce the economic risks associated

Dariusz K. Rosati 299

with FDI, such as the risk of a sudden change of economic regime, exchange rate risk and currency convertibility risk. The third impact of EU expansion will be on the size of the market. The removal of trade barriers will integrate the national markets of the CEEC accession countries with those of the EU to form one large regional market, and this is likely to induce a reallocation of production activities. In this process some new FDI is likely to flow into the new member countries, but the reverse is also possible: EU firms that invested in CEECs to avoid their import barriers could decide to discontinue production and replace it with direct exports. This, however, is rather unlikely, given the other locational advantages of the new members. On the other hand the expanded market is likely to have a positive effect on inflows of FDI from outside the EU, mainly from the United States and Japan, because intraregional trade is more attractive than extraregional trade (Gacs and Wyzan, 1998). Theoretical considerations therefore suggest that EU enlargement will have a strong and positive impact on FDI flows to the new member countries. While it is difficult to predict the magnitude of these flows, some inference can be drawn from the experience of earlier enlargements. Table 11.7

Table 11.7 Average annual FDI flows to the new EU member countries and share of total FDI flows to the EU and OECD countries before and after accession (million dollars and per cent)

Denmark (1973)1 Value Share of flows to EU (%) Share of flows to OECD (%) Ireland (1973) Value Share of flows to EU (%) Share of flows to OECD (%) United Kingdom (1973) Value Share of flows to EU (%) Share of flows to OECD (%) Greece (1981) Value Share of flows to EU (%) Share of flows to OECD (%) Portugal (1986) Value Share of flows to EU (%) Share of flows to OECD (%)

6–4 years before

1–3 years before

0–2 years after

3–5 years after

6–8 years after

– – –

131 2.5 1.4

240 2.5 1.5

⫺8.0 ⫺0.1 ⫺0.1

102 0.7 0.3

– – –

29 0.6 0.3

87 0.9 0.6

228 2.4 1.3

275 1.8 0.7

– – –

1490 28.5 15.7

3470 35.7 22.2

3743 39.2 21.9

7490 48.6 20.3

239 2.7 1.6

571 3.7 1.9

465 3.6 1.3

468 3.8 0.9

781 1.6 0.6

158 0.9 0.4

205 1.6 0.5

542 1.4 0.5

2265 2.8 1.5

1559 2.1 1.1

300 The Impact of EU Enlargement on Economic Disparities Table 11.7 Continued

Spain (1986) Value Share of flows Share of flows Austria (1995) Value Share of flows Share of flows Finland (1995) Value Share of flows Share of flows Sweden (1995) Value Share of flows Share of flows

6–4 years before

1–3 years before

0–2 years after

3–5 years after

6–8 years after

to EU (%) to OECD (%)

1661 9.9 4.4

1787 13.9 4.6

5014 13.0 4.7

11 635 14.3 7.7

10 260 14.0 7.2

to EU (%) to OECD (%)

533 0.6 0.4

1079 1.4 0.8

2055 1.9 0.9

– – –

– – –

to EU (%) to OECD (%)

343 0.4 0.4

950 1.2 0.8

1238 1.2 0.9

– – –

– – –

to EU (%) to OECD (%)

3382 3.9 2.2

3323 4.2 2.3

10 030 9.5 4.5

– – –

– – –

Note 1. Years of accession in brackets. Source: Zimny (1998).

lists the flows of FDI to nine member countries before and after their accession. It can be seen that the accession of the United Kingdom, Ireland, Austria and Sweden was associated with a substantial increase in FDI inflows, both in value terms and as a share of total inflows. Moreover the very prospect of accession seems to have attracted increased amounts of FDI to Portugal, Spain, Austria and Finland – as shown by the absolute and relative figures for the three-year period running up to accession. The two only exceptions to this pattern – for quite different reasons – were Denmark and Greece, with the latter country experiencing serious political instability in the run-up to and immediately after accession.14 The cases of Ireland and Portugal on the one hand and Greece on the other are particularly instructive. They demonstrate that EU accession is a necessary but by no means sufficient condition for attracting increased flows of FDI. What counts is political stability, overall economic performance and sound domestic and international policies. If these conditions are met, FDI is likely to flow in on a large scale. These observations are confirmed by the results obtained by other authors. Baldwin et al. (1997) made the first serious attempt to estimate the costs and benefits of EU enlargement. They used a macroeconomic simulation model that included nine regions and 13 sectors to estimate the real income (GDP) effects of the elimination of tariffs between the EU and CEECs

Dariusz K. Rosati 301

and the adoption of a common EU tariff. They also made a rough estimate of the likely reduction in transaction costs from the removal of frontier controls, the adoption of common standards and so on, which were assumed to amount to 10 per cent of all trade costs. Under the ‘conservative scenario’ – that is, excluding the impact of reduced risk on capital inflows – the estimated GDP gain for seven CEECs (the CE-8 plus Bulgaria, Romania and Slovakia and minus the Baltic countries) was ECU 2.5 billion, or some 1.5 per cent of GDP. However under the ‘optimistic scenario’ – that is, accounting for the impact on capital inflows of a fall in the risk premium of 15 per cent – the estimated gain was much higher, amounting to ECU 30.1 billion or 18.8 per cent of GDP. One of the conclusions of the study, therefore, was that the new member countries could expect very large inflows of FDI just before and after accession because of the greatly reduced political and economic risks. Such high figures for capital inflows and GDP gains are doubtful because they assume that the CEECs have a very high absorption capacity. Moreover the earlier EU enlargements were not associated with such massive GDP increases. But even if the optimistic scenario is unrealistic, a large-scale positive impact can still be expected. The results obtained by other authors are generally smaller in terms of GDP increases, but they are still substantial. Brown et al. (1997) estimate that the overall gains from EU accession will be 6 per cent of GDP, while Breuss (2001) – using a general equilibrium model – estimates that the static and dynamic effects of accession will be 8 per cent of GDP. Structural assistance programmes A clear benefit from EU expansion that will be strictly limited to the new members is that they will become eligible for the whole range of structural assistance programmes, involving large transfers of resources. These programmes can be classified under two broad headings: the Structural Funds and the Common Agricultural Policy (CAP).15 In early studies the predicted amount of Structural Fund transfers to new members in Central and Eastern Europe was set broadly at the same level as those allocated to Greece and Portugal, that is, about 200 ECU per capita up to 1993, and up to 400 ECU per capita after the Edinburgh summit decided to double the amount (Courchène et al., 1993). These forecasts quickly proved to be overly optimistic. At the Berlin summit in 1999 a new financial strategy for the EU was proposed in the form of Agenda 2000, which set broad guidelines on the financial and budgetary aspects of eastward enlargement. The financial package that was finalized at the Copenhagen summit in 2002 put the overall amount of financial aid to ten new members at €40.6 billion for the period 2004–6. This means that the average per capita transfers to the CE-8 countries will be about €180 per annum at most – much less than in previous enlargements. The actual amounts will almost

302 The Impact of EU Enlargement on Economic Disparities

certainly be lower because of the limited absorptive capacity of the new members. EU experience shows that only 65–80 per cent of potential Structural Fund transfers are actually made because of the problems that recipient countries have with finding good projects and raising the necessary ‘matching funds’. Nevertheless these are still significant transfers and amount to about 3 per cent of GDP. Depending on their composition and destination they may be expected to accelerate economic growth in the recipient countries by 0.6–1.0 per cent of annual GDP growth. The CAP is an important component of structural assistance. Early estimates of expected financial transfers under the CAP were very high – ranging from 31 billion to 37 billion ECUs per annum for the four Visegrad countries – which cast doubt on the feasibility of the plans to extend this form of structural support to new members from Central and Eastern Europe (see for example Tyers, 1994; Baldwin, 1994; Anderson and Tyers, 1995). These estimates have since been significantly revised downwards, taking into account the reduction in the CAP budget following the McSharry reform in 1995 and the limiting of direct transfers to farmers in new member countries to 25–40 per cent of those currently obtained by EU farmers. Economic costs It is sometimes argued that the costs of accession for the CEECs will include the need to restructure certain sectors (agriculture and heavy industry) and to adopt rather demanding EU standards in areas such as environmental protection, nuclear safety, transport and public security. It is true that all this will be very costly and will also have considerable social and political implications. But reforms in these areas will have to be conducted sooner or later, irrespective of EU accession – they are plainly inevitable if the processes of improving living standards in the CEECs and catching up with Western Europe are to be sustained. EU accession may bring forward the timing of these reforms, but the extra funds from the EU will help to finance them. Other costs linked to the opening of borders and the free flow of resources could include an outflow of highly qualified specialists to Western countries. One standard and fairly specific cost of accession is the obligatory contribution to the EU budget. After long and protracted negotiations the average contribution has been set at around 1.1–1.2 per cent of the accession countries, GDP – essentially at par with that of the present member countries. The actual payments will be reduced by special compensatory payments from the EU budget, including unconditional disbursements from the Structural Funds. Even accounting for these payments the budgetary burden of the mandatory contributions will be very large for the CEECs.16 The total contribution by the CE-5 countries will be about €4 billion, that is, three to four times less than the payments they will receive from Structural Fund and CAP transfers. The net balance of financial inflows and outflows will

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amount to €26–27 billion in 2004–6 – equivalent to 2.5–2.7 per cent of their combined GDP. The first ‘wave’ applicants, other applicants and non-applicants The first group of eight new members are the most advanced and most prosperous of the CEECs. The ‘left-outs’ – seven CEECs and the CIS-4 – have quite different statuses vis-à-vis the EU. Bulgaria and Romania have signed Europe Agreements with the EU, applied formally for membership and began negotiations in 1998, but they will have to work hard to accelerate growth and make decisive advances in structural reforms before they can realistically think about finalising the membership negotiations. Among the five remaining CEECs, Croatia has recently applied for EU membership and it can be expected to be admitted to the EU in 2007–8, together with Bulgaria and Romania. Croatia’s accession to the EU would be all but natural: as its main religion is Roman Catholicism and it was once part of the Austro-Hungarian Empire, historically and culturally the country clearly belongs in Europe. Economically, Croatia has recovered from the turbulent crisis caused by the violent disintegration of former Yugoslavia and its involvement in the war in Bosnia. Politically, the country has abandoned the nationalist policies followed by President Tudjman’s government, and has closely cooperated with the EU in implementing democratic reforms of its political system. As for the other CEECs, they have not applied for EU membership, or signed Association Agreements with the EU. Whether they will join the EU at some time in the future will depend on four factors: (1) how far and how rapidly they progress with domestic political and economic reforms, (2) the level of their economic development and overall economic performance, (3) the extent to which the European integration strategy would be supported by national political elites and the population at large, and (4) a positive attitude by the EU towards their possible integration. If these four conditions are satisfied, interested CEECs could gradually proceed towards closer integration with the EU, moving from trade and cooperation agreements to Association Agreements, and later towards full membership. Of these CEECs, the Former Yugoslav Republic of Macedonia has clearly expressed its interest in rapid association with the EU, and presumably full membership in the future. The country has made important progress in implementing market reforms and seems to be recovering from a protracted recession. However its overall level of economic and social development (see the indicators in Tables 11.1 and 11.2) is still relatively low, and domestic political stability is somewhat fragile because of the impact of the conflict in Kosovo on the position and status of the Albanian minority in the country. Also, Macedonia’s relations with neighbouring Greece are strained because of the dispute over the official name of the country. This dispute is complicating the country’s relations with the EU as a whole, so an Association

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Agreement with the EU is not likely to be put on the agenda in the near future. The other Balkan countries have even less chance of joining the EU for some time to come. Their history, religion and culture make them somewhat different from the West European countries, and they can be considered as ‘cleft countries’ (Huntington, 1996) situated between three major civilizations – Euro-Atlantic, Islamic and Orthodox. Moreover their state traditions – apart from those of Yugoslavia – are weaker and their level of economic development generally lower than in other European countries. Albania is one of the poorest countries in Europe, and the recent civil unrest has painfully demonstrated the fragility of democratic institutions and the weakness of the rule of law in that country. The Federal Republic of Yugoslavia, which consists of Serbia and Montenegro, has for several years been subject to economic and political sanctions by the international community for its continued military involvement in Bosnia and its policy towards ethnic minorities inside the country (most recently in Kosovo). Fundamental political changes began after the authoritarian and nationalistic regime of President Milosevi´c fell apart, but more time is needed to bring Yugoslavia’s internal politics close to European standards. On the economic side, the country has lost more than 50 per cent of its precrisis income level and an undisclosed but probably very substantial part of the national wealth (infrastructure, housing, education, health care and so on). Clearly Yugoslavia will need a long period of recovery and comprehensive reforms before it can realistically think of becoming part of the EU, even as an associated country. And it is probably too early to assume that a strategic orientation towards Europe would be the preferred choice of the Yugoslav population, or whether it would gain sufficient support from the EU. It is equally difficult to predict the future of Bosnia-Herzegovina – a newly established but deeply divided country where state institutions and the national identity are still in the making. Finally, the strategic orientation of each of the four CIS countries is even more uncertain. Russia and Belarus seem to be heading for close integration that may in future develop into a broader economic area, perhaps also including some Asian republics. Recent declarations by top Russian officials have made it clear that Russia has no ambition to join the EU, although it is interested in close economic cooperation. By contrast Ukraine and Moldova have openly expressed their interest in joining the EU (and other European structures such as CEFTA). It remains to be seen whether this interest will be maintained and whether the idea of a European, rather than a CIS, orientation will continue to receive strong popular support. If this proves to be the case, the two countries should be given a fair chance to integrate with Europe at some point in the future.

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Potential problems with ‘left-outs’ The ‘left-out’ countries are not only economically less developed, they are also politically more unstable than the more advanced CEECs and are often involved in covert or open conflicts with their neighbours. These countries’ lack of a clear perspective for welfare improvement and/or security arrangements could easily lead to adverse social and political developments, such as mass migration, the revival of militant nationalism, ethnic conflicts, authoritarian regimes and so on. This course of events would probably trigger defensive reactions of a protectionist and/or separatist nature by other countries, leading to increased tension between the rich and the poor parts of the continent. Such a situation would be economically costly for both sides, and eventually dangerous for European stability. It is therefore in the interest of the EU and the more advanced CEECs to help the ‘left-outs’ to catch up by providing financial and technical assistance and involving them in the integration process. This would not only reduce the potential for instability and conflicts, but also make their economies more attractive as markets for EU exporters and importers, and for international investors. It should be noted that the very prospect of joining the EU (and/or NATO) can have a powerful stabilising effect. This has been confirmed by the experience of Hungary and Romania. In 1996 the dispute that had been long simmering between the two countries with regard to the rights of ethnic Hungarians in Romania was resolved within a few months as the two countries rushed to meet the political criteria for NATO membership. Similar considerations played a role in the settlement of a border dispute between Romania and Ukraine in 1997. From this point of view the scope for potential membership should be large. All the differences and doubts notwithstanding, it is theoretically possible to think not only of Croatia and Macedonia but also Yugoslavia and even Bosnia, Albania, Ukraine and Moldova as prospective EU members. Even if cultural, political and economic differences at present render this possibility unrealistic if not impossible, there are important arguments in favour of considering their future accession. First, all the CE-7 countries have achieved a considerable degree of economic integration with the EU. This can be measured by the EU’s share of their foreign trade, compared with the shares of other regions. Table 11.8 shows that while the EU has a lower share of these countries’ exports and imports than its share of trade with the CE-8, it is much larger than the CE-7’s share of trade with other countries in Central and Eastern Europe and the CIS. The EU accounts for almost 50 per cent of total CE-7 trade, and this share is even higher for some countries. Albania, Croatia and Yugoslavia have stronger trade links with the EU than has Bulgaria, even though the latter enjoys preferential treatment under the Europe Agreement. Most of

306 The Impact of EU Enlargement on Economic Disparities Table 11.8 Transition countries, regional shares in trade, 1997 EU EU CEECs CEECs CIS CIS in exports in imports in exports in imports in exports in imports Czech Republic Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia Total CEEC-8

59.9 48.6 71.1 48.9 32.5 64.0 45.0 63.6 63.9

61.5 61.3 62.2 53.2 46.5 63.8 39.5 67.4 63.0

24.4 15.8 10.9 13.9 14.6 9.4 41.2 23.1 15.8

15.3 5.7 7.6 18.3 15.6 6.9 29.1 14.1 9.8

5.1 26.3 8.2 29.4 46.4 15.4 7.2 4.9 10.0

8.0 17.4 11.3 19.7 29.3 8.2 18.5 3.0 8.7

Albania Bosnia-Herzegovina Bulgaria Croatia Macedonia (FYR) Romania Yugoslavia Total CEEC-7

87.5 23.9 43.3 49.7 37.9 56.5 60.5 47.8

83.8 49.9 36.5 59.4 37.2 52.5 53.1 48.9

9.0 56.1 9.3 34.8 38.6 7.0 17.1 22.0

8.5 41.2 6.3 17.3 33.5 7.0 16.4 17.3

0 2.8 17.4 4.7 2.7 6.2 7.4 13.2

0.5 0.4 32.8 5.4 10.5 14.8 9.1 16.1

Belarus Moldova Ukraine Russia Total CIS-4

6.7 10.3 12.3 32.9 28.3

16.5 19.9 19.7 37.0 30.9

8.7 11.0 12.6 15.7 14.8

8.9 18.6 11.9 10.1 10.5

73.7 69.6 39.3 19.5 26.2

66.9 51.6 57.7 32.8 38.0

Source: UN ECE (1998).

the CE-7 countries are also linked to the EU financially – for instance the domestic currencies of Croatia and Yugoslavia are directly tied to the euro, which is circulated in parallel to those currencies. Of course simple trade shares are not a perfect measure of the real degree of economic integration; what counts more in this context is the intensity of intra-industry trade, which measures the extent of real and structural links in production, including international production networking (Landesmann, 1998). Such links between the EU and the CE-7 may be much weaker than between the EU and the CE-8 (UN ECE, 1998, p. 135) but the EU is nonetheless the most important CE-7 trading partner. The second argument is therefore very straightforward: the CE-7 do not have other international markets to turn to, and in the absence of alternatives they will naturally gravitate towards the EU. Neither the CIS nor other countries (for example Turkey) can provide an alternative orientation for their economic development. The situation is distinctly different for the CIS countries, of which Russia has the largest economy. While its geographical trade structure is more or less balanced the EU’s share is relatively high. However, Belarus, Moldova

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and Ukraine have maintained very strong trade links with the CIS countries and their share of trade with the latter is much higher than that of the EU. Clearly the CIS economies have continued to focus on trade with each other, despite the centrifugal tendencies observed after 1990, with Russia maintaining its position as the centre of gravity for the whole CIS region. Further integration of the CIS area is likely as all these countries belong to the same civilization and have a common history, religion and culture. The third argument for considering all the CE-7 countries as prospective EU members combines economic and political aspects. Being located in Europe, these countries have a role to play in maintaining regional security and stability. If some of them are permanently excluded, not only will this hamper their prospects of economic development but it is also likely to translate into political instability and strengthen the tendency to externalize domestic economic and social problems. This could lead to permanent tension between them and the enlarged EU, with more and more resources being needed to contain them. The possibility of future membership, conditional on meeting a set of well-defined though demanding criteria, would probably be a better strategy for pan-European stability and prosperity than stopping the enlargement process after the second wave and leaving a permanent cleavage across the continent. Finally, there is the ‘civilization’ argument. While the three Balkan countries have different cultural and historical roots than the rest of Western and Central Europe, geographically they are part of Europe and have had a long association with mainstream European culture. Hence, they are ‘cleft’ countries17 whose orientation is probably not yet decided (Huntington, 1996). If these countries were permanently excluded they would be forced to look for alternative alliances to protect their national security and interests, for example with Russia or the Islamic countries. If that happened they could become an arena for conflicts between the united Europe and other civilizations on issues such as human rights, organized crime and arms trade. Moreover their geostrategic position could also cause internal struggles between pro-Europeans and advocates of other geostrategic choices. From this point of view, too, it makes sense to make an effort to draw them into a united Europe.

Policy implications and recommendations Is there a risk of a new division in Europe? A key conclusion of the above analysis is that if EU enlargement is limited to the more advanced CEECs the new members will benefit from opportunities that will not be available to other CEECs (such as increased FDI inflows, access to structural funds and participation in the EU decisionmaking process). Furthermore membership of NATO will increase the security and stability of the advanced CEECs. These factors will widen the present

308 The Impact of EU Enlargement on Economic Disparities

economic distance between the more advanced and less advanced transition countries. The excluded CEECs, although still closely linked through trade to EU markets, are likely to suffer a deterioration of their relative position in trade and international investment flows. This will generally increase the cost of economic growth in those countries and almost certainly widen the development gap between them and the more advanced CEECs. As shown earlier, EU membership is certain to induce increased capital flows to the new member countries, thus accelerating growth. Taking the mid-range estimates by Brown et al. (1997) and Breuss (2001) of the dynamic effects of this – that is 7 per cent of additional GDP – and adding Structural Fund transfers of 3 per cent, there will be a permanent increase in national income levels by an average of 10 per cent. Assuming that only half of this will be spent on additional gross capital formation, GDP growth will accelerate by about 1.2–1.3 per cent per annum (with incremental capital to output ratio of 4). The increase in income levels plus the acceleration of growth by 1.2 per cent will widen the gap between the CE-8 countries and other CEECs, so in 20 years the present division into Western Europe and Central and Eastern Europe could be replaced by a division between Central and Western Europe on the one hand and Eastern Europe on the other. One cannot say with certainty that this scenario will materialize, but all the arguments put forth above suggest that the development gap between the CE-8 and CE-7 countries is likely to increase substantially over the coming years. This calls for a long-term strategy by the less advanced CEECs, based on three main pillars. First, they should pursue sound domestic economic policies and continue their reforms in order to establish solid institutional and macroeconomic foundations for growth and improved living standards. Second, they should strategically aim at integrating themselves with the EU in terms of institutional adjustments plus economic and political cooperation. Third, they should develop broad cooperative relations among themselves in order to reduce the potential for regional conflicts and increase the development advantages of the region. This triple strategy is briefly discussed below. Domestic and external policies: towards ‘quasimembership’ The less advanced CEECs would be well advised to follow growth-oriented economic policies in order to accelerate the catching-up process. Conservative macroeconomic policies are needed to reduce inflation and restore balance in public finances, especially in countries with a record of high inflation and high deficits. Macroeconomic stabilization should be combined with further deregulation of domestic markets and opening up to international markets. This should be paralleled by appropriate structural policies, including privatization, the restructuring of problematic sectors and policy measures to attract FDI. Much more attention should be

Dariusz K. Rosati 309

paid to institution building. In particular, adherence to the rule of law is a precondition for investment and sustained growth – the experience of more advanced CEECs demonstrates that once macro stability is established and the rule of law observed, foreign investment will increase and economic growth will quickly resume. Institutional reform should be modelled on and harmonized with EU practices to achieve the status of quasimembership. This would facilitate the catching-up process through reduced uncertainty and lower transaction costs, which would encourage more trade and foreign investment. It would also ensure institutional convergence and de facto integration that could open the door to EU accession in the future. Policy convergence should proceed gradually and without undue zeal. Excessively ambitious targets for inflation or the government budget – especially when key market institutions are still absent or only rudimentary – would be ill-advised as they would hamper economic growth and lock the less advanced countries into a low growth equilibrium. They could also be politically costly and erode popular support for market reforms (as demonstrated recently by events in Russia and Ukraine). The experience of the most successful transition countries and the recent experience of international financial crises suggest that pragmatic policies work better. Liberalization, privatization and internal convertibility should be implemented as soon as possible; but the state should not disappear altogether from the economic scene – rather it should change its role to ‘market maker’ and ‘law enforcer’. The role of the EU in regional cooperation: towards cohesion and unity in Europe An important part of establishing reasonably reassuring prospects for the excluded CEECs would be for the EU to define clearly the criteria for inclusion, including the future boundaries of the EU, in order to help potential candidates to adjust their domestic policies accordingly. It should be stressed that the CEECs have practically no alternative for regional integration other than with the EU. Turkey seems to be back on track for future EU membership, but Russia is economically much too weak. Willing or not the ‘leftouts’ will gravitate towards the EU, and the EU, also willing or not, will be largely responsible for their future development. In this context the EU should develop a long-term strategy vis-à-vis the less advanced CEECs. The arguments developed at the end of the previous section suggest that an important part of this strategy would be to offer the possibility of EU membership at some point in the future under clearly specified conditions. The gradual convergence of the CEEC economies towards the EU should be supported by increased aid and broader assistance programmes. A serious internal debate within the EU is needed to gain a better understanding of the implications of limited expansion and the benefits that might be obtained from further enlargements.

310 The Impact of EU Enlargement on Economic Disparities

A similar policy should be adopted for those CIS countries which are likely to make a strategic choice in favour of European integration, primarily Ukraine and Moldova. Even though these two countries still have a long way to go in terms of institutional and economic advancement, their strategic pro-European orientation should be welcomed and supported. The unilateral convergence process should be supported by initiatives to strengthen the existing and establish new forms of regional cooperation among the CEECs. In this regard a positive role could be played by the Central European Initiative, CEFTA, the Council of the Baltic Sea States and the South-East Economic Cooperation (SEEC). These are useful regional initiatives that have brought together countries with different ethnic, cultural and economic backgrounds but with a common and turbulent 600-year history and common (not always very friendly) borders. Now they also have common goals. Progress in regional cooperation, especially at the popular level, will depend very much on eliminating old phobias and stereotypes. The role of regional organizations will be to restore old and establish new links of cooperation and good neighbourliness between the member countries. This role will be of utmost importance, given the deeply rooted ethnic and national animosities in the region. Notes 1. This chapter is based on a study conducted for the Central European Initiative and the United Nations Economic Commission for Europe. The opinions expressed in the chapter are those of the author and do not necessarily represent the views of the UN ECE, the CEI or the National Bank of Poland. The author is grateful for comments by Yves Berthelot, Jorge Braga de Macedo, Paul Hartig, Martin Kern, Gabor Oblath, Paul Rayment, Gian-Luca Sambuccini and Marian Svetlicic. 2. In this context it is worth recalling that one of the strongest criticisms of the Versailles Treaty of 1919 was its failure to address economic issues. As Keynes (1919, p. 211) rightly observed, the treaty contained ‘no provisions for the economic rehabilitation of Europe, nothing to stabilize the new States of Europe, nothing to reclaim Russia’. 3. The ratio of standard deviation to arithmetic mean for the EU countries is 0.33 and 0.26 for GDP per capita in ‘official’ dollars and ‘PPP’ dollars respectively, while the same ratios for all CEECs are 0.82 and 0.49. 4. Defining an internationally comparable criterion of poverty is always a rather arbitrary task. In this study we follow the approach adopted by the UNDP in its annual Human Development Report, which sets the poverty line at an income of $14.4 per capita per day for the OECD countries and at $4 per capita per day for transition countries. 5. The proposition that the level of economic development on the periphery depends on the distance from the economic centre of gravity has been suggested by many authors. 6. For the role of institutions in market transformation see Murrell (1995) and KozulWright and Rayment (1997). 7. Adelman and Morris (1967), using principal component analysis, constructed an index of socioeconomic development that encompasses 22 social and political variables. Applying the analysis to 74 developing countries, the authors found

Dariusz K. Rosati 311 significant relationships between the index value and the growth of per capita GDP. Their methodology has recently been further developed and improved by Temple and Johnston (1998). The results confirm the existence of a strong link between social characteristics and economic growth. 8. This term, coined by Kornai (1993), describes the fall of output in the CEECs associated with the dismantling of the central planning system and the first wave of reforms in 1989–91. 9. The PIN index measures the potential for social instability, which may be assumed to be an increasing function of the level of poverty and inequalities in income distribution, and a decreasing function of the rate of economic growth per capita. To come up with a synthetic quantification of the first argument, it has been decided to use data on unemployment and the percentage of people living below the poverty line, since these can be interpreted as measuring both the poverty level and the extent of income distribution inequality. The GDP growth rates have been taken to represent the second argument. The index is constructed as a weighted composite in the following manner: PIN ⫽ 0.25(U) ⫹ 0.25(PL) ⫺ 0.5[r(GDP)]

10.

11.

12.

13.

14.

15.

16.

where U is the unemployment rate in 1997, PL is the percentage of people living below the poverty line in 1995, and r(GDP) is the average annual GDP growth rate in 1995–97. The PL values are 30 per cent for Albania and 20 per cent for Croatia, Macedonia and Yugoslavia. Specifically, inflation should not exceed that of the three lowest-inflation EU countries by more than 1.5 per cent; interest rates on long-term government bonds should not exceed the average of those in the same three countries by more than 2 per cent; the deficit to GDP ratio should not be higher than 3 per cent; the debt to GDP ratio should not exceed 60 per cent, and the exchange rate should stay within the band of permitted fluctuations under the ERM for two years without a realignment (see IMF, 1996, pp. 40–3). EU and ECB officials have recently warned against too rapid a nominal convergence, arguing that it would hamper growth in the EU candidate countries, and suggested a slower convergence towards the euro. Barro (1991), using data for 98 countries, found no statistical evidence of real convergence: the average growth rate of per capita real GDP from 1960 to 1985 was not significantly related to the initial (1960) value of real per capita GDP – the correlation was only 0.09. Various country-risk analysts, such as Euromoney and Institutional Investor, typically assign a weight of 25 per cent to the political risk element of overall risk, the same weight as they assign to the economic performance of a given country. The level of political and economic risk in Denmark was probably low even before the accession, which may partly explain the weak reaction of FDI flows. Another explanation could be that both in Denmark and Greece there was strong opposition to EU membership before and after accession, which could have increased uncertainty about the future relations of both countries with the EU. The Structural Funds include four separate programmes: the FEOGA (agriculture), the European Social Fund, the European Fund of Regional Development and the Financial Instrument for Fishery, which are spent on specific development objectives. Using a model of voting power in the EU, Baldwin et al. (1997) estimated an equation by regressing the levels of per capita contributions to the levels of per capita GDP. Applying the same equation to estimate the expected budgetary contributions

312 The Impact of EU Enlargement on Economic Disparities of the new members and assuming 5 per cent growth rates between 2000 and 2005 yielded figures that were considerably lower than amounts specified at the summit in Copenhagen. For example, for Poland the ‘theoretical’ contribution would be €1960 million, whereas the actual payment in 2005 will be €2540 million. 17. For instance Albania’s main religion is Islam, but the country has never steered toward fundamentalism and has supported laicization and a secular state. Yugoslavia and Bosnia-Herzegovina are multi-ethnic countries and the dominant religions (Eastern Orthodox and Islam, respectively) coexist with minority religions.

References Adelman, I. and C. T. Morris (1967) Society, Politics and Economic Development (Baltimore, MD: Johns Hopkins University Press). Anderson, K. and R. Tyers (1995) ‘Implications of the EC Expansion for European Agriculture Policies, Trade and Welfare’, in R. Baldwin, P. Haaparanta and J. Kiander (eds), Expanding Membership of the European Union (Cambridge: Cambridge University Press). Andreff, W. (1999) ‘Nominal and real convergence – at what speed?’, in J. Van Brabant (ed.), Remaking Europe. The European Union and the Transition Economies (Lanham: Rowman & Littlefield), pp. 111–38. Baldwin, R. E. (1994) Towards an Integrated Europe (London: CEPR). Baldwin, R. E, J. F. Francois and R. Portes (1997) ‘The costs and benefits of eastern enlargement: the impact on the EU and central Europe’, Economic Policy, vol. 24 (April), pp. 127–70. Baldwin, R. E and A. Venables (1995) ‘Regional Economic Integration’, in K. Rogoff and G. Grossman (eds), Handbook of International Economics, vol. 3 (Amsterdam: North-Holland). Barro, R. J. (1991) ‘Economic growth in a cross section of countries’, Quarterly Journal of Economics, vol. 106, no. 2, pp. 407–43. Barro, R. J. and X. Sala-i-Martin (1992) ‘Convergence’, Journal of Political Economy, vol. 100, no. 2, pp. 223–51. Breuss, F. (2001) ‘Macroeconomic Effects of EU Enlargement for Old and New Members’ WIFO Working Papers, no. 143 (Vienna: Austrian Institute of Economic Research). Brown, D., A. Deardorff, S. Djankov and R. Stern (1997) ‘An economic assessment of the Integration of Czechoslovakia, Hungary and Poland into the European Union’, in S. Black (ed.), Europe’s Economy Looks East. Implications for Germany and the European Union (Cambridge: Cambridge University Press), pp. 23–60. CSO (2001) Statistical yearbook 2001 (Warsaw: Central Statistical Office). Courchène, T., C. Goodhart, A. Majocchi, W. Moesen, T. Prud’homme, F. Schneider, S. Smith, B. Spahn and C. Walsh (1993) ‘Stable Money – Sound Finances’, European Economy, no. 53 (Brussels: European Commission, DG II). De Melo, M., C. Denizer and A. Gelb (1996) ‘From Plan to Market: Patterns of Transition’, World Bank, Country Economic Department Papers no. 1564; forthcoming in M. Blejer and M. Skreb (eds), Macroeconomic Stabilization and Transition Economies (Cambridge: Cambridge University Press). Drabek, Z. (1998) ‘Common External Tariff of the European Union and the Structural Adjustment in Central and Eastern Europe: Notes’, mimeo (Geneva: WTO). Dunning, J. H. (1993) Multinational Enterprises and the Global Economy (London: Addison-Wesley).

Dariusz K. Rosati 313 EBRD (1998) Transition Report 1998 (London: European Bank for Reconstruction and Development). EBRD (2002) Transition Report 2002 (London: European Bank for Reconstruction and Development). Fischer, S., R. Sahay and C. A. Vegh (1998) ‘How Far is Eastern Europe from Brussels?’, IMF Working Paper WP/98/53 (Washington, DC: International Monetary Fund, April). Gács, J. and M. Wyzan (1998) The European Union and the Rest of the World: Complements or Substitutes for Central and Eastern Europe? Interim Report (Vienna: IIASA, April). Havrylyshyn, O. and T. Wolf (1999) ‘Determinants of Growth in Transition Countries’, Finance & Development, vol. 36, no. 2. Huntington, S. (1996) The Clash of Civilizations (Cambridge, Mass.: Harvard University Press). Hunya, G. (1997) Foreign Direct Investment in Central and Eastern Europe (Vienna: WIIW and Bank Austria, April). IMF (1996) World Economic Outlook (Washington, DC: International Monetary Fund). Kawecka-Wyrzykowska, E. and D. K. Rosati (2002) ‘The impact of EU enlargement on non-EU candidate countries. Trade and investment effects’, paper prepared for UN ECE, November. Keynes, J. M. (1919) The Economic Consequences of the Peace (London: Macmillan). Kornai, J. (1993) ‘Transformational Recession. A General Phenomenon Examined through the Example of Hungary’s Development’, Discussion Paper, no. 1 (Budapest: Collegium Budapest, Institute for Advanced Studies, June). Kozul-Wright, R. and P. B. W. Rayment (1997) ‘The institutional hiatus in economies in transition and its policy consequences’, Cambridge Journal of Economics, vol. 21, no. 5, pp. 641–61. Landesmann, M. A. (1998) ‘East–West Integration: Vertical Product Differentiation, Wage and Productivity Hierarchies’, in J. Zysman and A. Schwartz (eds), Enlarging Europe: The Industrial Foundations of a New Political Reality (Berkeley: University of California), pp. 117–30. Levine, R. and D. Renelt (1992) ‘A Sensitivity Analysis of Cross-Country Growth Regressions’, American Economic Review, vol. 82, pp. 942–63. Molle, W. (1994) The Economics of European Integration. Theory, Practice, Policy, 2nd edn (Aldershot: Dartmouth). Murrell, P. (1995) ‘The Transition According to Cambridge, Mass’, Journal of Economic Literature, vol. 33, no. 1, pp. 164–78. Richter, S. (1998) ‘WIIW Position Paper on the European Union’s Eastern Enlargement’ (Vienna: Vienna Institute for International Economic Studies, March). Rojec, M. (1998) ‘Foreign Direct Investment. How Much NATO and EU Membership Enhance Investments by Non-EU Investors?’, unpublished manuscript. Romer, D. (1996) Advanced Macroeconomics (New York: McGraw-Hill). Temple, J. and P. A. Johnston (1998) ‘Social capability and economic growth’, The Quarterly Journal of Economics, vol. CXIII, pp. 965–90. Tyers, R. (1994) ‘Economic Reform in Europe and the Former Soviet Union: Implications for International Food Markets’, Research Report, no. 99 (Washington, DC: International Food Policy Research Institute). UNCTAD (1997) Trade and Development Report (Geneva: United Nations). UNDP (2002) Human Development Report (Geneva: United Nations Development Programme). UN ECE (1998) Economic Survey of Europe (New York and Geneva: United Nations Economic Commission for Europe).

314 The Impact of EU Enlargement on Economic Disparities UN ECE (2002) Economic Survey of Europe (New York and Geneva: United Nations Economic Commission for Europe). Zimny, Z. (1998) ‘Integracja a zagraniczne inwestycje bezposrednie: doswiadczenia Unii Europejskiej i wnioski dla Polski’ (Integration and foreign direct investment: EU experiences and implications for Poland), mimeo (Geneva: UNCTAD). Zysman, J. and A. Schwartz (1998) ‘Enlarging Europe: The Industrial Foundations of a New Political Reality’, in J. Zysman and A. Schwartz (eds), Enlarging Europe: The Industrial Foundations of a New Political Reality (Berkeley: University of California), pp. 1–27.

12 Prospects for Further (South-) Eastern EU Enlargement: From Divergence to Convergence? Vladimir Gligorov, Mario Holzner and Michael A. Landesmann

Introduction This chapter looks at the experiences of South-East Europe, which for the purposes of this chapter comprises the former states of Yugoslavia minus Slovenia (that is, Croatia, Serbia-Montenegro, Bosnia-Herzegovina and Macedonia), Albania and the two EU candidate countries, Bulgaria and Romania. For all these economies, accession to the EU will be the main driving force behind the policy-making agenda for the foreseeable future, albeit with considerably different time horizons. The reason why we shall treat these countries as a group – even though, as we shall see below, they differ quite markedly in many respects – is that for more than any other set of economies (with the possible exception of Turkey) the EU accession agenda will dominate the countries themselves and the way in which the outside world views them in the coming years. We shall discuss the prospects for EU enlargement to the south-east in two main sections. The first describes how in the 1990s the South-East European (SEE) countries fell behind in the process of economic development relative to the group of Central and East European (CEE) economies that are set to join (together with the Baltic states, Malta and Cyprus) the EU in 2004. The chance of their making up for this lost decade will be a crucial issue when evaluating the prospect of further EU expansion. The second section discusses in greater detail the conditions required to move towards sustained growth in the catching-up process. It analyses the problematic states of transition in some of the SEE economies as well as basic disequilibria (fiscal, external, labour markets) that need to be resolved if sustained development is to take place. It also discusses stumbling blocks that may inhibit the SEEs and the EU from developing a clear perspective of integration.

315

316 Prospects for Further Enlargement

South-East Europe versus Central and Eastern Europe: the track record so far This section contrasts the economic development of the SEE region with that of the ‘first round’ CEE transition economies. Table 12.1 presents some basic data on the size of the different economies, their per capita GDP (at current exchange rates and in purchasing power parity) and the level of the respective GDPs in relation to the 1990 levels. According to most of the indicators there is considerable heterogeneity within both groups. Starting with the size variable, we can see that there is one economy in each of the groups – Romania in the SEE group and Poland in the CEE group – that accounts for a very substantial share of the regional population and GDP. Therefore in most of the figures contained in this chapter when we present some summary information about the two regions, these two large entities will be excluded and their statistics presented separately so that regional developments will not be obscured by the performance of these two economies. In the SEE countries, with the exception of Croatia, per capita GDP is significantly below that of the CEE region. A major reason (in some countries the only reason) for this gap is the loss in output after 1990. It is clear that the 1990s was a decade in which the SEE region fell significantly behind the CEE region, although there has been some improvement over the past few years. Table 12.1 Basic indicators, SEE and CEE countries, 2002 Population GDP Per capita GDP (million (million Per capita (US dollars Real GDP persons) euros) GDP (euros) at PPP) (1990 ⫽ 100) Albania Bosnia-Herzegovina Bulgaria Croatia Macedonia Romania Serbia-Montenegro

3.11 3.83 7.8 4.41 2.01 22.4 8.3

Czech Republic Hungary Poland Slovakia Slovenia

10.2 10.2 38.6 5.4 2.0

4 908 5 574 16 6685 23 820 3 9165 48 384 14 000

1 590 1 475 2 125 5 368 1 925 2 161 1 679

4 0002 6 4004 8 250 10 030 6 520 6 590 4 500 2

123.3 – 87.9 92.9 87.3 92.3 52.86

73 855 65 8525 1 99 549 25 144 22 3675

7 248 6 487 5 168 4 675 11 208

15 740 13 550 10 510 12 820 18 530

107.2 115.6 146.5 111.6 127.4

Notes 1. Data for 2001. 2. Estimated figure for 2002. 3. Data for 2000. 4. Estimated figure for 2001. 5. Projected figure for 2002. 6. Based on gross material product (GMP). Source: WIIW database.

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 317

Figures 12.1 and 12.2 show developments over the period 1990–2002. As indicated above, the aggregates for the CEE-4 (the Czech and Slovak Republics, Hungary and Slovenia) and the SEE-4 (Bulgaria, Croatia, Macedonia and Serbia-Montenegro)1 are presented separately from the 160

140

120

100

80

60

40 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 CEE-4

Poland

SEE-4

Romania

Figure 12.1 Real GDP, CEE and SEE countries, 1990–2002 (1990 ⫽ 100) 105 100 95 90 85 80 75 70 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 CEE-4

Poland

SEE-4

Romania

Figure 12.2 Employment levels, CEE and SEE countries, 1990–2001 (1990 ⫽ 100)

318 Prospects for Further Enlargement

statistics for Romania and Poland. As can be seen, the CEE economies soon started to recover from the ‘transformational recession’ but the SEE economies experienced a significantly deeper fall and thereafter more or less stagnated until 1999. There were periods of weak recovery, but these were halted by political and economic ruptures: war between Serbia and Croatia in 1991–92 and again in 1995, a major banking and exchange rate crisis in Bulgaria in 1996, a banking crisis in Croatia in 1997, the collapse of the Albanian pyramid schemes in 1997, wars in Bosnia-Herzegovina in 1992–95 and Kosovo in 1999, and a civil war in Macedonia in 2001. Some sustained growth was achieved in 2000–2, when the SEE-4 and Romania enjoyed a growth rate of 3.9 per cent, compared with 3.4 per cent for the CEE-4. After a long stretch with the highest growth rates, Poland grew by just 2.1 per cent. Hence the SEE-4’s ‘falling behind’ period seems to have come to an end, although the catching-up phase has barely begun. With regard to aggregate employment levels (Figure 12.2), the CEE region underwent a period of dramatic labour shake-out until about 1994, after which there was a strong recovery in Poland and a mild recovery in the CEE-4, followed by a further gradual decline (a number of these economies experienced macroeconomic recessions in the mid or late 1990s). Meanwhile the SEE countries experienced a deep and sustained decline in employment levels throughout the period. In 2001 employment in the CEE-4 was 87 per cent Table 12.2 Labour market indicators, SEE and CEE countries, 2002 (per cent) Unemployment rate Registered, end of period

LFS average

Economic activity rate1

Albania Bosnia-Herzegovina Bulgaria Croatia Macedonia Romania Serbia-Montenegro

14.52 40.02 16.3 21.5 – 8.1 31.2

– – 17.8 14.8 31.9 8.4 13.8

66.13 – 49.4 50.9 52.6 57.1 56.3

Czech Republic Hungary Poland Slovakia Slovenia

9.8 8.0 18.1 17.5 11.3

7.3 5.8 19.9 18.5 6.4

59.9 52.9 55.4 60.2 57.5

Notes 1. Labour force as percentage of working-age population (15 plus). 2. 2001. 3. 2000. Sources: WIIW database; CANSTAT statistical bulletin 2002/4; IMF; national labour force surveys.

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 319

of the 1990 level, while in the SEE-4 it was below 75 per cent. Table 12.2 shows estimates of the unemployment rates (by registration and according to Labour Force Surveys – the latter are regarded as more reliable and internationally more comparable) and economic activity rates (that is, the percentage of active labour force in the total working age population) in 2002. We can see that two of the SEE countries had extremely low activity rates (Bulgaria and Croatia) and two had very high rates (Romania and Albania). However there is evidence that the figures hide a substantial degree of disguised unemployment. The later unemployment figures for the CEE region are more reliable as they cover periods in which the reform of unemployment insurance schemes and employment exchanges, as well as improvements in the unemployment and employment registers, had taken place. The two measures of unemployment are much closer for the CEE region than for the SEE region. Another difference between the employment situation in the two regions is the much higher estimate for the SEE region of the ‘black’ or ‘grey’ economy. The labour market situation and the role of the informal economy will be discussed at greater length in the second section of this chapter. The next point is the abysmal performance of the SEE region in exports. Figure 12.3 plots the development of total exports in the two regions during the transition period. As can be seen, exports stagnated in the SEE countries throughout the period, but there was substantial growth in the CEE countries. Towards the end of the period SEE exports enjoyed some modest growth, but nothing like that in the CEE countries. The weakness in export activities and export structure will be further analysed below. With regard to 100 000

80 000

60 000

40 000

20 000

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 CEE-4

Poland

SEE-4

Romania

Figure 12.3 Exports from CEE and SEE countries, 1990–2001 (million euros)

320 Prospects for Further Enlargement

foreign direct investment (FDI), the political and economic situation in the SEE region clearly took a strong toll on their attractiveness to international investors: there was almost no flow of FDI into the region until 1997, in sharp contrast to the increasing flow to the CEE-4 between 1990 and 2001 (Figure 12.4). The structure of foreign investment (Table 12.3) was similar in the two regions, with manufacturing, financial intermediation, the trading sector and – depending on the speed of privatization – telecommunications and transportation attracting the largest proportion of FDI. Figures 12.5 and 12.6 chart the regions’ current account and the trade balances. In 2002 the current account deficit reached more than 6 per cent of GDP in five of the seven SEE economies. The CEE economies fared better, apart from Slovakia. That year the average current account deficit in GDP amounted to 7.7 per cent in the SEE-4 and 4.8 per cent in the CEE-4; the deficits for Romania and Poland were 3.4 per cent and 3.6 per cent respectively. With the exception of the Polish slow-down this difference cannot be attributed to higher GDP growth in the SEE region and thus reflects the structural weakness of the SEE economies. This point can be substantiated by looking at the difference between the current account and trade balances in Figures 12.5 and 12.6 and the balance of payments structure in Table 12.4. The very bad performance by the SEE economies in commodities trade was partly compensated by substantial flows of income from tourism in Bulgaria and Croatia, plus substantial private transfers, mostly from expatriates

2500

2000

1500

1000

500

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 CEE-4

Poland

SEE-4

Romania

Figure 12.4 Per capita FDI stock, CEE and SEE countries, 1990–2001 (US dollars)

Table 12.3 Foreign direct investment by sector, CEE and SEE countries, 2001 (stocks and shares at end of year, per cent) NACE code

Czech Republic

A,B Agriculture, forestry, fishing 0.2 C Mining and quarrying 1.7 D Manufacturing 37.6 E Electricity, gas, water supply 6.1 F Construction 1.5 G Trade, repair of motor vehicles etc. 15.1 H Hotels and restaurants 0.7 I Transportation, storage, 10.4 communications J Financial intermediation 14.8 K Real estate, renting and 11.4 business activities L Public administration, defence, – social security M Education – N Health and social work – O Other community, social and 0.6 personal activities Other unclassified activities – Total 100 Total, million US dollars 27 092

Hungary

Poland

Slovak Republic

Slovenia

Bosnia1,2 Albania1 (Sep. 1999)

Bulgaria3

Croatia Macedonia1,4

Romania1

1.6 0.3 38.8 8.9 1.1 13.4 1.7 6.8

0.1 0.2 41.2 2.8 5.2 11.4 1.2 10.7

0.3 0.7 43.8 0.2 0.8 10.5 0.7 13.9

0.02 – 36.2 0.8 ⫺0.04 13.9 0.6 4.8

– – 42.3 – 6.2 27.2 – –

3 – 65 – 2 1 – –

0.3 1.1 39.1 ⫺0.4 2.6 16.3 1.9 14.1

0.3 3.2 36.1 1.0 1.1 5.2 3.1 29.5

0.2 – 29.25 – 4.2 2.6 0.2 46.0

10.9 15.3

23.1 1.2

25.9 3.0

28.3 12.6

– –

6 19

18.3 3.4

18.9 1.3

15.3 1.4

– –

0.0

–

–

–

–

–

–

0.1

–

–

0.03 0.1 1.1

– – 3.1

– 0.03 0.3

0.01 0.03 0.4

– – –

– – –

0.3 0.0 0.3

0.04 – 0.2

– – –

– – –

– 100 53 152

0.004 100 4 687

1.1 100 802.5

17.0 100 4881.6

– 100 11 1866 23 5626

2.3 100 3 209

24.3 100 –

4 100 –

2.7 100 3974.8

– 100 4656.7

3.6 – 44.45 – 4.5 20.1 3.1 7.3

Notes 1. Adjusted to NACE. 2. Investments of more than KM1 million. 3. Cumulated inflow from 1998. 4. Cumulated inflows 1997–2001. 5. Industry total (C ⫹ D ⫹ E). 6. Hungarian FDI is based on a survey of the largest FDI enterprises, according to which total FDI stock in 2001 was $11 186 million (the BOP puts the figure at $23 562 million). Source: National statistics.

322 Prospects for Further Enlargement 5.0 0.0 –5.0 –10.0 –15.0 –20.0 –25.0

Slovenia

Slovakia

Poland

Hungary

Czech Republic

SerbiaMontenegro

Romania

Macedonia

Croatia

Bulgaria

BosniaHerzegovina

Albania

–30.0

Figure 12.5 Current account, SEE and CEE countries, 2002 (percentage of GDP) 0.0 –5.0 –10.0 –15.0 –20.0 –25.0 –30.0 –35.0 Slovenia

Slovakia

Poland

Hungary

Czech Republic

SerbiaMontenegro

Romania

Macedonia

Croatia

Bulgaria

BosniaHerzegovina

Albania

–40.0

Figure 12.6 Trade balance, SEE and CEE countries, 2001 (percentage of GDP)

working abroad (Table 12.5). Reliance on substantial transfers from abroad indicates that an economy is not able to generate itself sufficient income for its consumption requirements. Reliance on a substantial income from tourism for foreign exchange earnings is in itself not detrimental to an economy, but this income is likely to fluctuate (tourism is highly sensitive to

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 323 Table 12.4 Balance of payments structure, South-East Europe, 2001 (percentage of GDP) BosniaSerbia and Albania Herzegovina Bulgaria Croatia Macedonia Romania Montenegro Current account Goods and services, net Trade balance, net Commodity exports, fob Commodity imports, fob Services, net Transportation, net Tourism, net Other, net Income, net Compensation of employees, net Investment income, net Current transfers, net General government, net Other sectors, net

⫺6.3 ⫺19.5 ⫺25.0 7.4 ⫺32.4 5.5 – – – – –

⫺23.1 ⫺32.0 ⫺36.8 19.6 ⫺56.4 4.7 – – – 5.1 –

⫺6.2 ⫺7.6 ⫺11.7 37.7 ⫺49.4 4.0 ⫺0.8 4.7 0.1 ⫺2.2 0.3

⫺3.2 ⫺5.4 ⫺20.4 24.4 ⫺44.7 15.0 0.9 14.0 0.2 ⫺2.7 0.6

⫺6.9 ⫺15.7 ⫺15.2 33.6 ⫺48.8 ⫺0.5 ⫺0.5 ⫺0.4 0.4 ⫺1.1 –

⫺5.8 ⫺8.0 ⫺7.5 28.7 ⫺36.1 ⫺0.5 0.0 ⫺0.2 ⫺0.3 ⫺0.7 0.3

⫺5.9 ⫺22.8 ⫺27.0 19.1 ⫺46.1 4.2 1.7 ⫺0.2 2.7 ⫺0.2 –

– 13.2 – 13.2

– 3.8 – –

⫺2.6 3.7 1.0 2.7

⫺3.4 4.9 0.3 4.7

– 10.0 1.4 –

⫺1.0 2.9 0.6 2.3

⫺0.2 11.8 – –

Source: WIIW database.

business cycle developments in the source countries) and there is the possibility that the equivalent of a ‘Dutch disease’ phenomenon will arise, with high-income tourists contributing to a rise in domestic prices, leading to an overappreciated currency that detrimentally affects the rest of the tradable sector; this phenomenon is clearly visible in Croatia. Figures 12.7 and 12.8 show the shares of the primary, secondary and tertiary sectors in GDP and (recorded) employment, respectively. It is clear that in terms of GDP the agricultural sector in the SEE economies has a higher share of total economic activity than in the CEE economies. Interestingly – with the exception of Serbia-Montenegro and Romania – there is not a large difference between the two regions with regard to the share of tertiary activity. Traditionally a large share of services in an economy is taken as a sign that a higher stage of economic development has been reached, but this would not be the right interpretation in this context. Rather, in line with a number of indicators already discussed and other indicators to be discussed below, we interpret the relatively large share of services in the SEE economies as reflecting a weakness of industry. Indeed, together with the general ‘falling behind’ of industry the SEE economies during the 1990s relative to the more advanced transition economies, there was a particularly sharp process of deindustrialization that weakened industry to a much greater extent than was the case in the CEE economies. From a sectoral perspective, a significant recovery of industry in the SEE economies will be an indispensable factor in their catching up with the more successful CEE economies.2

324

Table 12.5 Private transfers, South-East Europe, 2000–1

Albania

Private transfers (US$ million) Private transfers (% of GDP) Private transfers (US$ per capita)

Croatia

Macedonia

SerbiaMontenegro

2000

2001

2000

2001

2000 2001

2000

2001

2000

2001

543 14.5 173

510 12.4 162

983 5.3 224

1 049 5.4 225

454 12.7 224

1 132 14 136

1 698 13.2 205

172 3.7 45

165 3.4 43

192 5.5 94

Note: These figures are not completely comparable to the balance of payments statistics in Table 12.4. Source: IMF.

BosniaHerzegovina

325 100

80

60

40

20

Tertiary sector

Secondary sector

Slovenia

Slovakia

Poland

Hungary

Czech Republic

SerbiaMontenegro

Romania

Macedonia

Croatia

Bulgaria

0

Primary sector

Figure 12.7 GDP structure, SEE and CEE countries, 2001 (percentage of total) Note: The statistics for Serbia and Montenegro are for 1999. Source: WIIW (2002).

Tertiary sector

Secondary sector

Slovenia

Slovakia

Poland

Hungary

Czech Republic

SerbiaMontenegro

Romania

Macedonia

Croatia

Bulgaria

100 90 80 70 60 50 40 30 20 10 0

Primary sector

Figure 12.8 Employment structure, SEE and CEE countries, 2001 (percentage of total) Note: Employee data for Macedonia and Serbia and Montenegro. Source: WIIW (2002).

326 Prospects for Further Enlargement

The very weak performance of industry in South-Eastern Europe is further evidenced by a comparison of productivity growth (Figure 12.9). The region’s performance was inferior to that of the CEE economies throughout the period, with the exception of Romania from 1998 onwards. Also interesting are the trends in wage rates and unit labour costs (ULCs) (Figures 12.10 and 12.11). The substantial rise in wage growth in the CEE economies outpaced productivity growth and led to rising ULCs. Wage growth was much slower in the SEE economies, as were ULCs. A traditional interpretation of this development would be that the CEE economies experienced a deterioration in their competitiveness compared with the SEE economies. We would dispute such an interpretation because it does not concur with what we have seen in terms of relative export developments and the trade balance situations of the two regions, and because the simple measurement of labour productivity with output at constant prices neglects the substantial upgrading process that has taken place in CEE export industries in terms of product quality (for more on this see WIIW, 2003; Landesmann and Stehrer, 2002). The productivity, export and trade balance indicators for the SEE region indicate that the upgrading process has barely begun (with the possible exception of Romania and Bulgaria) and hence the economies remain uncompetitive in spite of moderate wage growth and flat unit labour costs. Figure 12.12 summarizes a number of income or (alternatively interpreted) competitiveness indicators and clearly shows the income and wage gaps between the two sets of economies. Also clear is the rather special position of two economies: Croatia, which in terms of income indicators (but not in terms of export performance or commodity trade balance) clearly belongs more to the group of transition economies with high levels of income and wages, and Slovenia, which stands out as a high (real) income and wage economy amongst the CEE economies (and without problems with the trade balance). We shall now conduct a structural examination of the SEE economies in terms of patterns of trade specialization. In the following we employ two taxonomic classifications of industry clusters that have recently been used in an EU-wide assessment of competitiveness (this classification has also been used to analyse the competitiveness of CEE economies; see Havlik et al., 2003). The first taxonomy clusters industries (at the three-digit NACE level) according to factor intensity and a number of industrial organization criteria (for details of this classification see Peneder, 2001), and the second groups industries by the relative demand for low, medium and highly skilled labour. Figures 12.13 and 12.14 examine the SEE and CEE economies’ exports (in these figures CEE-8 refers to the CEE-4 plus Poland and three Baltic states) to the EU-15 according to these two taxonomies: the analysis shows in which industry clusters a country sends a relatively high or low share of exports to the EU-15. The comparison is quite revealing. Figure 12.13 shows the regions’ export structures according to the first taxonomy. In 1997–2001 in the CEE-8 there was a rise in the share of

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 327 250 200 150 100 50 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 CEE-4

Poland

SEE-4

Romania

Figure 12.9 Labour productivity in industry, CEE and SEE countries, 1990–2001 (1990 ⫽ 100)

600 500 400 300 200 100 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 CEE-4

Poland

SEE-4

Romania

Figure 12.10 Average monthly gross wages, CEE and SEE countries, 1990–2002 (euros)

technology-driven exports in manufacturing exports to the EU, peaking at almost 30 per cent in 2001. For most of the SEE countries this figure was much lower at around 5 per cent and with no clear trend (the temporary rise in Macedonia is assumed to have stemmed from the repair of aircraft). The opposite pertains to exports from marketing-driven industries (including food processing), with the CEE countries being well below the 10 per cent

328 400 350 300 250 200 150 100 50 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 CEE-4

Poland

Romania

SEE-2

Figure 12.11 Unit labour costs, CEE and SEE countries, 1990–2002 (1990 ⫽ 100)

30 000 25 000 20 000 15 000 10 000 5000

GDP per employed person (euros) Average yearly gross wages (euros, PPP)

Slovenia

Slovakia

Poland

Hungary

Czech Republic

SerbiaMontenegro

Romania

Macedonia

Croatia

Bulgaria

0

Average yearly gross wages (euros)

Figure 12.12 Indicators of competitiveness, SEE and CEE countries, 2001

20

15

10

5

0

1997

1998

1999

2000

Romania

SerbiaMontenegro

CEE-8

SerbiaMontenegro

CEE-8

Macedonia

Croatia

Bulgaria

Romania

Macedonia

Croatia

Bulgaria

CEE-8

SerbiaMontenegro

Romania

Macedonia

Croatia

Bulgaria

BosniaHerzegovina

(e) 25

BosniaHerzegovina

0

BosniaHerzegovina

20 Albania

40

Albania

(d) 60

Albania

CEE-8

SerbiaMontenegro

Romania

Macedonia

Croatia

Bulgaria

BosniaHerzegovina

Albania

CEE-8

SerbiaMontenegro

Romania

Macedonia

Croatia

Bulgaria

BosniaHerzegovina

Albania

(a) 30 20

10

0

(b) 50

40

30

20

10

0

(c) 50

40

30

20

10

0

2001

Figure 12.13 Exports to the EU: (a) technology-driven industries; (b) marketing-driven industries; (c) capital-intensive industries; (d) labour-intensive industries; (e) mainstream industries, 1997–2001 (percentage of total manufacturing exports to the EU)

330 Prospects for Further Enlargement (a) 15 10 5 Romania

SerbiaMontenegro

CEE-8

Romania

SerbiaMontenegro

CEE-8

Romania

SerbiaMontenegro

CEE-8

Romania

SerbiaMontenegro

CEE-8

Macedonia

Croatia

BosniaHerzegovina BosniaHerzegovina BosniaHerzegovina

Bulgaria

Albania Albania Albania

0

(b) 30 20 10 Macedonia

Croatia

Bulgaria

0

Macedonia

Croatia

Bulgaria

(c) 40 30 20 10 0

1997

Macedonia

Croatia

Bulgaria

BosniaHerzegovina

Albania

(d) 100 80 60 40 20 0

1998

1999

2000

2001

Figure 12.14 Exports to the EU: (a) high-skill industries; (b) medium-skill/whitecollar industries; (c) medium-skill/blue-collar industries; (d) low-skill industries, 1997–2001 (percentage of total manufacturing experts to the EU)

level and most SEE countries well above it. Albania’s exports fluctuated around 40 per cent in this category. The picture of exports from capitalintensive industries is mixed, while the shares of exports from labourintensive industries (including textiles) show the relatively large importance of these industries in South-East Europe. Most SEE countries’ exports in this category accounted for about 40 per cent of total manufacturing exports to the EU. Mainstream industries (including various machinery products) accounted for about 20 per cent of CEE exports, a value that was also reached by Croatia in the latter years. The values for the other SEE countries were in the 5–15 per cent range. Figure 12.14 shows the export structures for the second taxonomy. In general, compared with the CEE countries the SEE countries tended to have

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 331

lower shares of high-skill industries in total manufacturing exports to the EU, but significantly higher shares of low-skill industrial exports. With the exception of Croatia, exports from low-skill industries accounted for well above 60 per cent of the SEE countries’ total manufacturing exports to the EU. With regard to the relative competitiveness of the two groups of economies, a number of additional important factors should be taken into account when analysing this issue: internal and external macroeconomic balances, institutional developments and progress in the transition process, the workings of the product, labour and capital markets, and so on. A number of these issues will be discussed in the next section, but we cannot complete the comparison of the structural characteristics of the SEE and CEE economies without considering an important distinguishing characteristic between the two: the size and potential impact of the informal sector. Following Schneider and Enste (2000) we can distinguish three sets of methods to measure the size and development of the shadow economy: direct approaches (for example sample surveys and tax auditing), indirect approaches (national accounts discrepancies, official and actual labour force discrepancies, the transactions approach, the currency demand approach and the physical input method) and model approaches (for example Dynamic Multiple Indicators Multiple Causes, DYMIMIC). Schneider (2002) used the currency demand, physical input and DYMIMIC approaches to estimate the size of the shadow economies of 110 countries. Table 12.6 shows the results for the SEE and CEE countries. In most SEE countries the unofficial sector accounted for well above 30 per cent of GNP in 1999–2000; in the CEE countries the percentage was generally much lower. However Schneider admits that the figures for Albania, Bosnia-Herzegovina and Serbia-Montenegro are unreliable due to distortions stemming from war and political unrest, and that the actual figures are likely to be much higher. IMF (2003) estimates for Albania indicate that the majority of economic activities in that country are informal. Bajec (2001) calculates that the share of the grey economy in Serbia’s GDP is above 40 per cent. A similar estimate for Bosnia-Herzegovina is provided by Efendic (2002). According to Eliat and Zinnes’ (2000) estimate for Macedonia, the shadow economy accounted for more than 130 per cent of GDP in 1997. Thus the estimated size of the informal economy can vary widely according to the method used. However there is little doubt that the share of the shadow economy in the SEE countries is considerably higher than in the CEE countries. We shall return to the role and impact of the informal sector in South-East Europe in the next main section. Summary This section compared the track records of the SEE and CEE economies since the beginning of transition. The picture that has emerged is that the SEE region has fallen behind the CEE region. This is clearly visible in the former’s

332 Prospects for Further Enlargement Table 12.6 Shadow economy, SEE and CEE countries, 1999–2000 (percentage of GNP) Albania1 Bosnia-Herzegovina1 Bulgaria Croatia Romania Serbia-Montenegro1

33.4 34.1 36.9 33.4 34.4 29.1

Czech Republic Hungary Poland Slovakia Slovenia

19.1 25.1 27.6 18.9 27.1

Note 1. War and political unrest means that these figures are unreliable. Source: Schneider (2002), p. 14.

GDP profile, abysmal employment record, and extremely bad productivity and export performance. Behind its fragile current account situation are very weak commodity trade balances and overreliance on transfers from abroad or on sectors (tourism) with negative structural and exchange rate implications. Its export structure is very different from those of the more successful transition economies, with an emphasis on export commodities that rely mostly on unskilled labour and low technology inputs. The CEE economies on the other hand, have made good progress in exports from medium- to high-skill and medium- to high-tech industries. We have also hinted at other negative aspects of the SEE economies (such as the large share of the informal sector), that have implications for the way in which the labour, product and capital markets function. It is too early to determine whether the SEE economies are irreversibly stuck in a ‘development trap’ or are about to embark upon a similar development path to that followed by the more successful transition economies, with a considerable time lag but perhaps at a faster speed. In our opinion the prospect of EU accession and the requirement to meet the EU criteria will be extremely important to the region’s future development path, which is likely to be differentiated in terms of speed and pattern across the region. As important will be domestic behavioural, structural and policy responses. We shall consider these two sets of issues in the following section.

Sustainability, growth and integration with the EU Because of their less than successful transition and military and other conflicts, the SEE countries face considerable problems in their effort to achieve

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 333

macroeconomic stability and sustainable growth. They have problems not only with their external and fiscal balances but also with their levels of unemployment. Growth is elusive because some of the most important sources of growth are absent, especially exports and foreign direct investment. These countries have either lost their competitiveness or failed to make gains in it. Moreover their integration with the European Union has been delayed. In order to catch up, they must address the interrelated issues of stability, growth, competitiveness and integration. Macroeconomic stability Three balances are important here: debt, fiscal and resources, particularly the allocation and utilization of labour. Foreign debt As discussed earlier, unlike the CEE countries the SEE countries have failed to develop their export sectors. Indeed Hungary’s exports exceed the combined exports of the SEE countries (Albania, Bosnia-Herzegovina, Bulgaria, Croatia, Macedonia, Serbia-Montenegro, and Romania). Meanwhile imports have soared, so their trade deficits are high. The deficit in their current accounts is smaller because in general they have a surplus in services, income balances and transfers, as shown earlier in Tables 12.4 and 12.5. The dynamics of foreign debt in the region depend on at least three factors. Foreign debt tends to increase faster if a transition country is not initially very indebted. The same happens if a country does not fully service its inherited debt. At the beginning of transition the inherited debt is usually restructured and a period of grace is allowed, during which time indebtedness tends to grow. Finally, the stock of debt tends to stagnate if foreign direct investment (FDI) flows into a heavily indebted country. Thus, the SEE countries are vulnerable to increases in debt service, for whatever reason, and to a slowdown in FDI. To put this another way, their current approach to foreign debt is sustainable as long as the costs of borrowing do not deteriorate and there is a steady inflow of FDI. Another way of looking at the issue of debt sustainability is to estimate the future debt to GDP or debt to export ratios (Table 12.7). Assuming the desired level of reserves remains constant, the debt to GDP ratio can remain constant if the interest rate on the debt is the same as the growth rate of GDP. Then refinancing the debt will keep the debt to GDP ratio at the same level. To keep the debt to GDP ratio constant the difference between the interest rate and the growth rate should be repaid. For instance, if the growth rate is 4 per cent and the interest on the foreign debt is 6 per cent, the difference of 2 per cent should be repaid. If the debt to GDP ratio is 50 per cent, 1 per cent of GDP should be repaid each year to keep the debt level constant. Clearly every fall in the growth rate will result in a need to repay more to prevent the debt from growing.

334 Table 12.7 External debt indicators, South-East Europe, 2001–3 2001

20021

20031

Albania External debt (% of GDP) External debt (% of exports) Short-term external debt (% of reserves) External debt service (% of exports)

28.7 140.7 2.6 3.9

24.7 138.8 6.2 7.8

25.5 141.9 6.7 7.1

Bosnia-Herzegovina External debt (% of GDP) External debt (% of exports) External debt (% of reserves) External debt service (% of exports)

53.2 186.4 207.0 5.8

51.6 184.9 224.3 8.3

50.6 179.8 231.9 10

Bulgaria External External External External

debt debt debt debt

(% of GDP) (% of exports) (% of reserves) service (% of exports)

78.3 140.9 296.6 –

70.3 137.1 – –

64.8 131.5 – –

Croatia External External External External

debt debt debt debt

(% of GDP) (% of exports) (% of reserves) service (% of exports)

57.9 117.5 240.6 24.4

67.9 144.5 259.0 25.9

– – – –

Macedonia External debt (% of GDP) 40.7 External debt (% of exports) 115.6 Short-term extended debt (% of reserves) 32.4 External debt service (% of exports) 19.0

42.4 126.3 21.9 11.9

– – – –

Romania External External External External

29.6 88.1 240.6 4.4

28.6 83.9 190.8 4.5

– – – –

113.7 441.4 120.1 1.8

– – – –

– – – –

– – – –

100.0 391.7 529.8 2.0

– – – –

– –

41.9 108.6

– –

debt debt debt debt

(% of GDP) (% of exports) (% of reserves) service (% of exports)

Serbia-Montenegro External debt (% of GDP) External debt (% of exports) Short-term external debt (% of reserves) External debt service (% of exports) Serbia External External External External

debt debt debt debt

(% of GDP) (% of exports) (% of reserves) service (% of exports)

Montenegro External debt (% of GDP) External debt (% of exports)

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 335 Table 12.7 Continued

External debt (% of reserves) Public debt service (% of exports)

2001

20021

20031

– –

– 10.4

– –

Note 1. Projections. Sources: IMF; national statistics.

This has implications for the trade balance (and thus the current account). If all the debt is refinanced but for the difference between the interest rate and GDP growth rate, that difference stands also for the necessary surplus in the current account or the trade balance that is needed to keep the debt to GDP ratio constant. Otherwise the debt will grow faster than GDP and will eventually become unsustainable. In the SEE economies the seeds of unsustainability are certainly there. There is no doubt that the interest rates they have to accept are higher than their rates of growth. They also run high trade and current account deficits. Therefore their debt to GDP ratios can only be held down by higher inflows of FDI. At the moment the debts can be financed, but essentially they are not sustainable under normal conditions. It is hard to judge the severity of the SEE countries’ indebtedness because the debt level at which the ratio of debt to GDP should be stabilized is not clear. Conventionally a ratio of 60 per cent has been used. Three countries are above that threshold: Bulgaria, Serbia-Montenegro and Croatia. Some have suggested a ratio of 30 per cent because of the unreliability of GDP estimates, in which case most of the SEE countries would be above that threshold. Perhaps more reliable measures are the debt to export and debt service to export ratios. For most countries these are less worrisome, although for Croatia and Serbia the debt service to export ratio is quite high (in the case of Serbia this is not evident from the current data, but when the period of grace expires in 2006 the ratio will jump to at least 25 per cent). The improvement that can be observed for some countries is due to the recovery of exports of services (mainly tourism), but this growth will inevitably slow and the debt burden will continue to increase. In the meantime significant amounts of aid are still flowing into the region and some countries or territories are continuing to obtain credits at concessionary interest rates, which are less difficult to service than at commercial interest rates. Fiscal sustainability Fiscal sustainability is probably even more important than foreign debt from a developmental point of view. Most of the SEE countries have rather high public expenditure to GDP ratios. Over 50 per cent, in some cases, which

336 Prospects for Further Enlargement

fall short of expenditures implying significant general government deficits. As shown in Tables 12.8 to 12.10 the SEE governments, with some exceptions, spend a lot on wages and salaries, have a substantial defence expenditure, expend considerable sums on subsidies and transfers, and make significant interest payments on public debt. The real state of public finances is difficult to determine because of the presence of substantial contingent fiscal liabilities, or fiscal risks. In a number of SEE countries the state has had to bear the costs of restructuring a number of sectors, such as the banking sector and state-owned enterprises, and these costs are hard to assess. However it can be assumed that the fiscal situation is much worse than the data on revenues and expenditure suggest. In most countries the primary balance is negative (Table 12.8). In other words the region’s governments are in deficit even if interest payments on the public debt are excluded. Assuming that the deficit is financed from borrowing, stability requires the deficit to be no larger than the additional GDP. Otherwise debt will grow faster than the GDP and ever larger debt repayments will be required to keep the debt at an acceptable level. At the moment this eventuality is being held at bay by a large, though diminishing, supply of aid. It can be expected that some forms of budget support will be provided in the future, partly from the EU.

Table 12.8 General government data, in South-East Europe, 2001–3 (percentage of GDP) 2001

20021

20031

Albania Revenues Expenditure Overall balance Interest payments Primary balance Defence expenditure

23.0 31.5 ⫺8.5 4.3 ⫺4.2 1.1

23.5 31.0 ⫺7.5 3.7 ⫺3.8 –

24.4 31.0 ⫺6.6 3.8 ⫺2.8 –

Bosnia-Herzegovina Revenues Expenditure Overall balance Interest payments Primary balance

51.8 57.5 ⫺5.7 1.2 ⫺4.5

52.2 56.2 ⫺4.0 1.1 ⫺2.9

50.7 52.8 ⫺2.1 1.1 ⫺1.0

Bulgaria Revenues Expenditure Overall balance Interest payments Primary balance

37.7 38.6 ⫺0.9 3.7 2.8

36.0 36.7 ⫺0.7 2.2 1.5

35.6 36.3 ⫺0.7 2.4 1.7

337 Table 12.8 Continued 2001

20021

20031

3.2

3.4

3.3

Croatia Revenues Expenditure Overall balance Interest payments Primary balance

44.7 51.5 ⫺6.8 2.2 ⫺4.6

45.4 51.5 ⫺6.1 2.3 ⫺3.8

45.0 50.0 ⫺5.0 2.5 ⫺2.5

Macedonia Revenues Expenditure Overall balance Interest payments Primary balance Defence expenditure

34.4 40.4 ⫺6.0 1.8 ⫺4.2 10.3

33.4 36.8 ⫺3.4 1.6 ⫺1.8 5.9

– – – – – –

Romania Revenues Expenditure Overall balance Interest payments Primary balance

30.5 33.7 ⫺3.2 3.9 0.7

30.2 33.1 ⫺2.9 3.2 0.3

30.4 33.1 ⫺2.7 2.9 0.2

Serbia-Montenegro Revenues Expenditure Overall balance Interest payments Primary balance

42.0 43.6 ⫺1.6 0.8 ⫺0.8

44.0 48.4 ⫺4.4 2.6 ⫺1.8

43.5 47.6 ⫺4.1 – –

Defence expenditure

Note 1. Projections. Sources: IMF; national statistics.

Table 12.9 General government spending on wages and salaries, South-East Europe, 2001–3 (percentage of GDP)

Albania Bulgaria Croatia Romania Serbia and Montenegro Slovenia SEE average

2001

2002

2003

5.6 3.9 11.7 5.0 10.1 10.0 6.1

5.2 3.9 11.1 5.0 10.1 10.2 –

5.0 3.9 10.5 4.9 9.9 – –

Sources: IMF; national statistics.

338 Prospects for Further Enlargement Table 12.10 Subsidies and transfers, SouthEast Europe, 2001–3 (percentage of GDP)

Albania Bulgaria Croatia Romania Serbia-Montenegro Slovenia SEE average

2001

2002

2003

8.9 16.2 20.8 14.5 21.1 20.0 18.3

9.0 16.4 20.6 14.6 25.4 20.4 –

8.6 17.0 20.2 14.5 23.2 – –

Sources: IMF; national statistics.

The high share of public expenditure in GDP and the persistent deficit mean that taxes will have to be kept high or expenditure reduced. The growth consequences of raising taxes would probably be negative, not only because of the high fiscal burden but also because of the misallocation of resources through distorting taxes and preserving the existing expenditure structure3. Therefore expenditure cuts will be preferable. Significant savings could be made by spending much less on security, that is, by making use of the peace dividend. Restructuring the public sector could also improve the fiscal balance. By contrast not much can be done about social security. While widespread inefficiencies could be rectified, thus cutting costs, pension expenditure will remain high because the populations in the region, with the exception of the Albanian and Muslim populations, are rather old. The SEE countries are unable to invest much in infrastructure because of the pressure of current expenditures and because their budget deficits put a limit on new borrowing. Even when external financing is available, the necessary domestic cofinancing is hard to come by. This is impeding the improvement of infrastructure and preventing other types of modernization investment. In general, therefore, expenditure is biased towards consumption and away from investment, and towards the older rather than the younger generation. This will have significant consequences in terms of economic development and the emigration of workers. Employment During transition an increase in unemployment can be expected. While employment tends to fall more slowly than output it also recovers more slowly. At the start of transition employment is still predominantly in the state sector and may perform a social or political purpose, but later it is mostly in the private sector, where the need to increase productivity dominates. In South-East Europe the violent conflicts significantly contributed to the dynamics of this, making the fall in output and in employment quite steep and delaying the recovery of both output and employment. As a

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 339

consequence, and as discussed earlier, employment has remained low and unemployment high, in some cases very high. The official employment and unemployment statistics in the region are not reliable because they exclude activities in the large informal sector. One indication of the existence of this is the discrepancy between registered unemployment and that found in labour surveys. In the former Yugoslav countries the difference is as much as 10 per cent or even 20 per cent of the labour force. If one assumes that there are also people who are registered as unemployed but are in fact working in the informal economy – full time or moonlighting – then the size of the informal sector must be significant. The estimates in Table 12.6 above may be exaggerated, but there is no doubt that the share of the informal economy is higher in the SEE countries than in CEECs. Nonetheless, common sense assumptions about the productivity of that sector do not support the suggestion that the informal sector is practically the largest sector in the SEE countries (although Albania and Kosovo may be exceptions). The problem with the SEE labour markets is that they are not efficient, in the sense that it is probable that labour is misallocated in both the formal and the informal economy. The informal economy always involves tax evasion (though this may not be the reason why it emerges) so in effect it is subsidized. The labour employed in that sector at least to some extent misallocated, because the sector would occupy a different role in the economy if it were paying taxes. The formal economy is either subsidized or still facing somewhat soft budget constraints. It is also probably still hoarding labour. Thus all this contributes to misallocation of labour in the economy. If the above is correct, then a significant reallocation of labour will have to take place, with misallocated labour in both sectors moving to the new private formal sector. The aggregate effect of this is not easy to predict with certainty. What can be said, however, is that the usual reallocation of labour from the state to the private sector during transition will have to be augmented with reallocation via the informal sector, with the additional risk of the economy being stuck in a low-development equilibrium – a characteristic of the ‘transition with organized crime’ that can be observed in many parts of South-East Europe. Sources of growth The foregoing analysis of imbalances is important to understand the sources of growth in the past and those which may be important in the future. Episodes of growth in South-East Europe have been the result of one or more of the following: ● ● ●

Postconflict reconstruction. Increased consumption. Increased investment, either public or in the form of FDI.

340 Prospects for Further Enlargement

Only growth based on FDI has generally not led to imbalances with negative growth consequences, and even where it has it was incorrect targeting of FDI that was to blame. Most foreign investors have targeted sectors such as telecommunications, banking and industries with predominantly domestic markets (for example breweries, tobacco, oil and energy). Their contribution to efficient resource allocation has been significant, but they have contributed less to sustainable growth. A good example is the banking sector. The share of foreign-owned banks in the South-East Europe is higher than in Central Europe. However their contribution to the growth of output has been rather modest. The main reason for this is that the banks have been eager to finance consumption but less ready to finance capital investment. This became clear during the euro conversion in 2002, when the liquidity of the banks in many countries increased significantly. Most of this went into loans to households, most of which were spent on durable consumer goods. This served to increase imports, so had little effect on the growth of output. A comparison of the sources of growth in the Central European transition countries with those in South-East Europe indicate that export growth is essential. Most of the SEE economies are small, the exception being Romania. Therefore the best strategy for growth is probably market integration. However markets have tended to disintegrate in the region, partly as a result of sanctions and embargoes. This situation started to change after the war in Kosovo in 1999. Indeed since then the SEE countries have been doing better, with the exception of Macedonia, which experienced a severe ethnic conflict and from which it is still recovering. The barriers to trade, however, are still significant, particularly non-tariff barriers. If one views political barriers as prohibitively high non-tariff barriers – that is, zero quotas on trade between two countries or territories – it becomes clear that the barriers to trade in the region are quite high. This accounts for the low levels of trade within Bosnia-Herzegovina, between Serbia and Kosovo and between Serbia and Croatia (see Christie, 2002). To address tariff barriers the SEE countries have signed a series of bilateral free trade agreements. The next step will be the creation of the Southeast European Free Trade Area (SEEFTA). In addition, and more importantly, the EU has unilaterally removed all tariff and most non-tariff barriers to imports from Albania, Bosnia-Herzegovina, Croatia, Macedonia and SerbiaMontenegro. These measures have been helpful, although there have been no dramatic increases in foreign trade yet. Still, there can be no doubt that market access will be important for sustained and rapid growth in the region. The same can be said of enterprise restructuring. Unlike in Central Europe, a new private sector has not burgeoned in South-East Europe. Furthermore, the small and medium-sized enterprises that have emerged in the formal and informal economies have concentrated mainly on trade and other

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 341

services. The growth of private sector industry has been much less pronounced. As a consequence of the above, much of the enterprise sector has remained in state hands (or socially owned, in the case of former Yugoslavian countries). The future performance of these enterprises will depend heavily on the speed of privatization, as their restructuring and revitalization has not proved to be much of a success. To date privatization has often been guided by special interests and not by increased efficiency in the use of resources, so much more attention should be paid to improving the structure of corporate governance. Competition policy could contribute to the restructuring of enterprises. The state sector is populated by monopolies, and the structure of the privatized sector (and of the informal economy) is not necessarily one that can be associated with a free market economy. To some extent the combination of postsocialist structures with inadequate rule of law have kept the incentives for exit low and the costs of entry high. This is changing with the increasing openness of SEE economies, but the process is slow and is standing in the way of reforms to the structure of the economy. Another impediment is the large share of the informal economy, which mostly consists of small and medium-sized firms in low value added sectors. Informality puts a cap on the size of firms, except in the case of so-called ‘captured states’. Even without the rule of law, the sheer fact of informality works against large-scale production. Thus there are limits to the growth of the informal economy. As touched on above, sustained growth would be aided by the growth of exports. Here the issue of competitiveness comes in. Unlike the more successful CEE transition economies, most SEE economies have adopted a fixed exchange rate, which was a consequence of a lack of belief in the ability of the monetary authorities to withstand pressure to monetize the fiscal deficit. Among the problems that this has caused depressed exports and runaway imports are probably the most serious. There is hope that real restructuring will eventually validate the chosen exchange rate policy, but there is no sign of this yet. In any event there is no doubt that increased competitiveness will be the key to sustained growth and eventual convergence with the more developed transition economies and the EU. European integration The SEE countries are more integrated with the EU than with each other. The EU is their most important trading partner, even in the case of landlocked countries or territories such as Serbia, Macedonia, Kosovo and Bosnia-Herzegovina. Assuming that the SEE countries will eventually adopt an export-based growth strategy, exports to the EU will feature largely, as they have for the CEE economies. This will be true not only of goods but also of services, as the region has comparative advantages in tourism,

342 Prospects for Further Enlargement

transportation and perhaps some other sectors. At the moment most of these services are exported to the EU member states. The EU is also the main investor in the region, and it is likely that EU investments will increase with the accession of Hungary and Slovenia, which have already been investing in SEE countries and will probably continue to do so. At the moment these investments are rather low, partly because of uncertainty about the prospects of these countries’ integration into the EU. The EU is also an important source of factor incomes and transfers (see Tables 12.4 and 12.5), with the remittances, wages and pensions of migrant workers being quite crucial to the balance of payments. Private transfers range from 5 per cent in Croatia to over 10 per cent in many other countries. The recent increases in private transfers to Romania and Bulgaria have mostly come from the EU, although the share of transfers from other countries is quite significant. Finally, the EU is the main source of aid and public transfers. In the west of the region most of these inflows have been connected with reconstruction and humanitarian aid. In other countries they have increasingly been connected with transition and EU integration. It can be expected that the EU will increase its financial support, with funds being targeted at macroeconomic stability, employment growth and the institutional changes required for EU integration. Clearly the SEE countries are dependent on the EU, and this dependency goes beyond economic factors. The EU plays a quite significant political role, and in some cases a direct one, for example in Bosnia-Herzegovina, Kosovo, Macedonia and Serbia-Montenegro. Both the economic and the political roles would be significantly enhanced if the SEE countries adopted appropriate strategies for EU integration. The EU is committed to the accession of the candidate countries and to its Stabilization and Association Process (SAP) with the western Balkan countries,4 which began in 1999. The latter consists of a Stabilization and Association Agreement (SAA), which is similar but not identical to the Europe Agreements. At the moment, SEE–EU relations are as follows: ● ●

● ●

Candidates for membership: Bulgaria and Romania. SAAs: Macedonia and Croatia (signed with the EU and in the process of ratification by the individual member states). Cooperation agreement: Albania, SAA negotiations in progress. No contractual relations: Bosnia-Herzegovina and Serbia-Montenegro, with SAAs to be offered some time in the future.5

The EU’s strategy is currently under revision. Probably the first item in the new strategy will be a clear commitment on both sides to the process of integration. The next will concern the lead that the EU should take, which will be both necessary and difficult to expect, for two reasons. First, the SEE

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 343

countries have been slow to adopt an EU integration agenda, partly because of internal difficulties and partly because of regional problems. There have been few if any initiatives at the regional level, and there is no shared recognition of the advantages of EU integration. Second, the benefits of EU membership will be significantly greater for the SEE countries than those accruing to the EU, especially when the extent of these countries’ economic dependence on the EU is taken into account. Thus it cannot be expected that the EU will be interested in speeding up their integration. To deal with the first of these problems a strategy for regional integration has been devised, that is, in order for the individual countries to qualify for a deepening of their relationship with the EU they must make progress in regional cooperation. Because of the imminent EU enlargement and political changes in South-East Europe, things have started to move in this respect, or at least at the level of political will. Most countries and territories are now putting EU integration ahead of other political interests, which in turn is putting pressure on the EU to start thinking more seriously about their future membership. One possible strategy would be to treat the SEE countries as de facto candidates for membership.6 This implies the use of instruments that would enable the EU to have a more pronounced role in the settlement of outstanding political issues, to provide more resources, both financial and technical, and to contribute to the economic recovery of the region through better access to EU markets and increased FDI from the EU. Implementation of this strategy would require a lot of innovative thinking by both the EU and the SEE countries. A key issue would be trade within the region and with the EU. The current arrangements, which are based on association agreements with the EU and bilateral trade agreements between SEE countries, are full of distortions. In view of the central importance of the EU market for these countries’ economies and of their lack of competitiveness, unilateral trade liberalization on the EU’s side would be useful, as would multilateral trade liberalization within the region. With regard to inward flows of investment, a lowering of country-specific and regional non-commercial risks would be desirable. As the banking sector in the region is dominated by banks from the EU member states, some scheme of loan guarantees should not be difficult to devise. On the macroeconomic side, fiscal sustainability is probably the key issue. As for monetary policy, in most SEE countries the euro is used more than the domestic currency, and as a consequence most countries have adopted a fixed exchange rate. This has proved beneficial for price stability but has had a negative effect on competitiveness. Thus designing appropriate monetary and exchange rate policies is essential. Addressing the region’s microeconomic problems would require institution building and microfinancing. Reliance on public resources could be the preferred approach, but it might not be the best one as public money tends to be misused in the region. Thus key issues would be the securing of private

344 Prospects for Further Enlargement

money and mechanisms for its mobilization and utilization. In the end, the inflow of FDI and export growth should lead to a process of convergence.

Conclusion Transition has resulted in divergence for the SEE countries. They have not succeeded in improving their competitiveness and have not started on the path to sustainable growth. The situation has improved since 2000, but the increase in growth has been accompanied by macroeconomic disequilibria. Moreover in most cases growth has been driven by consumption rather than investment and exports. Hence there are still considerable problems to address. This would be easier if the process of EU integration was speeded up. The Balkans are quite dependent on the EU both economically and politically. Thus unlike in other cases where convergence preceded integration, the opposite might be preferable for the SEE countries. Notes 1. For Albania and Bosnia-Herzegovina the existing data are too patchy to allow comparisons. 2. Developments in Central and Eastern Europe were also characterized by a sharp deindustrialization in the early phases of the transition process, but this was followed in quite a few of the countries by some recovery of industry, often induced or accompanied by substantial FDI inflows, strong productivity growth and improved product quality (for more details see Landesmann, 2000). 3. For further information see Gligorov (2000). 4. Albania, Bosnia-Herzegovina, Croatia, Macedonia and Serbia-Montenegro. 5. Gligorov (2002). 6. Ibid.

References Bajec, J. (2001) ‘Reintegration of the grey economy and the improvement of the business climate in Serbia – Policy Recommendation’, report for the sixth Economic Policy Forum round table, Belgrade, January. Christie, E. (2002) ‘Potential Trade in Southeast Europe: A Gravity Model Approach’, WIIW Working Papers, no. 21 (Vienna: Vienna Institute for International Economic Studies, March). Efendic, A. (2002) ‘Macro policy for poverty reduction – Bosnia and Herzegovina’, paper prepared for the Poverty Reduction Strategy Forum for Albania, Bosnia and Herzegovina and Yugoslavia, Baden, Austria, 29 October to 1 November. Eliat, Y. and C. Zinnes (2000) ‘The Evolution of the Shadow Economy in Transition Countries: Consequences for Economic Growth and Donor Assistance’, CAER II Discussion Paper, no. 83 (Cambridge: Harvard Institute for International Development, September). Gligorov, V. (2000) ‘State in the Balkans’, in Vladimir Gligorov (ed.), Balkan Reconstruction: Economic Aspects (Vienna: Vienna Institute for International Economic Studies).

Vladimir Gligorov, Mario Holzner and Michael A. Landesmann 345 Gligorov, V. (2002) ‘European Union Enlargement and the Balkans’, in A. Warner (ed.), European Competitiveness and Transition Report (Oxford: Oxford University Press), pp. 114–25. Gligorov, V. (2003) ‘From Second Best to First Best Policies’, unpublished manuscript. Havlik, P., M. Landesmann, W. Urban and R. Wieser (2003) ‘Enlargement and Competitiveness’, in WIFO, European Competitiveness Report 2003 (Vienna: Vienna Institute for International Economic Studies, April). IMF (2003) ‘Albania: Selected Issues and Statistical Appendix’, IMF Country Report, no. 03/64 (Washington, DC: IMF, March). Landesmann, M. A. (2000) ‘Structural Change in the Transition Economies, 1989–1999’, in UN-ECE, Economic Survey of Europe, nos 2–3 (Geneva: UN-ECE). Landesmann, M. A. and R. Stehrer (2002) ‘Evolving Competitiveness of CEECs in an Enlarged Europe’, Rivista di Politica Economica, nos 1–2, January–February, pp. 23–88. Peneder, M. (2001) Enterpreneurial Competition and Industrial Location (Cheltenham: Edward Elgar). Schneider, F. (2002) ‘The Value Added of Underground Activities: Size and Measurement of the Shadow Economies of 110 Countries all over the World’, paper presented at a workshop held by the Australian National Tax Centre, Canberra, June. Schneider, F. and D. Enste (2000) ‘Shadow Economies Around the World: Size, Causes, and Consequences’, IMF Working Paper, no. 0026 (Washington, DC: IMF). WIIW (2002) WIIW Handbook of Statistics: Countries in Transition 2002 (Vienna: The Vienna Institute for International Economic Studies). WIIW (2003) ‘Competitiveness of Central and Eastern European Industries – Now and in an Enlarged EU’, study commissioned by Bank Austria Creditanstalt (Vienna: Vienna Institute for International Economic Studies, January).

13 The Impact of EU Enlargement on Countries beyond the New Frontiers Oleh Havrylyshyn1

Introduction Accession to the EU is by no means the only mechanism for economically integrating with Europe. As Emerson (1998) notes, there exist various formal arrangements that are less comprehensive than EU membership, including customs union (Turkey), partnership and cooperation agreements (Russia, Ukraine and Moldova) and the Barcelona process, which will eventually lead to free trade with the EU (Mediterranean countries). Furthermore there are multilateral initiatives without a core, such as the Organization for Security and Co-operation in Europe (OSCE). Whether such alternatives are adequate substitutes, highly imperfect substitutes or vehicles for accession will not be addressed in this chapter. Instead, given the fairly widespread perception – particularly in countries interested in closer involvement – that EU accession is a superior vehicle for integration, it makes sense to focus on accession effects. This chapter will analyse the effects of enlargement on those countries which have been omitted from the process (the ‘left-outs’). Leaving aside the possibility that the countries so designated may not appreciate being labelled ‘left-outs’, we shall begin by defining this group as countries whose prospect of accession in the foreseeable future is very dim, although things may change in the distant future. At this juncture it seems reasonable to include in this group Russia, Ukraine and the other CIS countries. In the twelve concentric circles of economic integration identified by Emerson (1998), Russia, Ukraine and Moldova are in the sixth concentric circle, and the Caucasus and Central Asia are in the ninth.2 Disregarding the waves of accession that one knows will take place, the accession countries are defined quite broadly (Table 13.1), even though some will not join in the near future. 346

Oleh Havrylyshyn 347 Table 13.1 Basic economic data and exports to EU, 2001 GDP per capita Population (US dollars (thousand) at ER)

GDP (billion US dollars at ER)

In % of own exports

In % of EU imports

2.13 5.72 12.08 3.14 22.37 1.53 1.48 309.93 1.06 2.68 37.56 11.62 411

25.8 69.5 11.1 41.2 23.3 24.7 21.4 38.7 32.8 11.3 20.3 21.2 33.6

0.004 0.072 0.037 0.010 0.090 0.005 0.005 1.423 0.009 0.006 0.132 0.019 1.812

Exports to EU

Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgyz Republic Moldova Russia Tajikistan Turkmenistan2 Ukraine Uzbekistan Total CIS

3 8 9 5 14 4 3 144 6 4 49 24 279

802 081 990 1011 842 908 635 819 250 845 037 4881 798

1

560 708 209 616 507 311 407 140 169 581 766 475 470

Czech Republic Hungary Poland Slovakia Slovenia Bulgaria Romania Total CEEC-7

10 10 38 5 1 8 22 96

224 188 641 380 992 020 409 854

5 5 4 3 9 1 1 3

514 078 737 804 443 690 772 962

56.38 51.73 183.04 20.46 18.81 13.55 39.71 383.69

68.9 74.3 69.2 59.9 62.2 54.7 67.8 68.3

1.024 1.009 1.114 0.337 0.256 0.125 0.344 4.207

1 2 3 7

364 355 481 200

4 3 3 3

050 200 445 479

5.52 7.54 11.99 25.05

69.4 61.2 47.9 57.8

0.102 0.054 0.098 0.254

3 928 20 903

408.74 7 890.6

67.6

4.462

Estonia Latvia Lithuania Total Baltics

Total CEEC-7 ⫹ Baltics 104 054 EU-15 377 480

1 1

2

Notes 1. In 2000. 2. The data on per capita GDP and GDP are for 1997. Sources: WIIW; Directions of Trade Statistics.

With regard to measuring the potential effects on countries excluded from accession, the literature on economic integration effects is of little help. To date most studies have focused almost entirely on the two integrating partners and say little or nothing about third parties, except to label them ‘rest of world’ in diagrams. Winters (1997) corrects this shortcoming in an invaluable manner, summarizing the handful of empirical estimates that have been made of the effects on third parties. However the methodology used for such estimates is quite formidable so we shall not attempt to develop the extensive econometric modelling framework needed to calculate the potential effects on the CIS countries. Rather we shall review, in a

348 The Impact of EU Enlargement on Outside Countries

preliminary fashion, three main channels of effects: (1) trade flows (diversion versus creation), (2) investment flows and (3) labour and human capital flows. Only for the first of these channels can some quantification be attempted, albeit very much in the nature of a partial equilibrium. Furthermore we shall not address exchange rates and monetary arrangements. Berrigan and Carré (1997) have studied these issues, and with regard to third countries state that the euro may become attractive as a vehicle currency or reserve asset. There is no reason to believe that the effect will be different for the CIS countries. The remainder of this chapter is organized as follows. The next section provides some background information and discusses differences between the initial conditions prevailing in the CIS countries and those in Central Europe with a good to reasonable prospect of accession. The latter are defined here, perhaps too generously, as the leading five plus the rest of the Baltic states, Slovakia, Bulgaria and Romania. The third section addresses the balance of trade-diversion and trade-creation effects and makes some tentative calculations of their order of magnitude. The fourth section discusses the effects of investment flows, and the fifth considers the movement of labour and human capital. The final section summarizes the main conclusions.

Background and initial conditions The potential effect on third parties of an integration process such as EU accession will depend, inter alia, on the countries’ level of development, the relative size of their markets, their trade dependence vis-à-vis the integrating economies and their comparative advantage. Table 13.1 provides an overview of these conditions, with the exception of comparative advantage, which is addressed in more detail in the next section. In terms of size, the population of the CIS group is nearly three times larger than that of the potential accession candidates (285 million versus 106 million), which for the sake of convenience are loosely defined as Central Europe, although of course Russia alone accounts for half of that figure. Measured in terms of aggregate GDP the CIS countries have the larger market, albeit proportionately far smaller than its population would warrant ($583 billion versus $340 billion).3 The significance of this is that even if the CIS countries lose to the acceding countries because of trade diversion and greater investment attraction, the size of their actual and potential markets (in terms of both population and GDP) is considerable and this will help to offset any negative effects. It should be noted, however, that taking account of the fall in per capita GDP in Russia to a level of about $2000 after the crisis of 1998, the aggregate GDP for the CIS countries amounts to some $425 billion, that is, 25 per cent more than that of the group of potential accedents. Thus in GDP terms the size of the Central European market is nearly as large as that of the CIS countries. Any growth in Central Europe resulting from EU accession will of course provide new trade-creation opportunities for the CIS countries.

Oleh Havrylyshyn 349

The magnitude of trade diversion for CIS exports depends not only on the countries’ relative comparative advantage structure vis-à-vis Central Europe and other third-party exporters to the EU, particularly developing countries, but also on the CIS countries’ relative share of EU imports compared with the other groups of competitors. It is notable that – with the exception of Russia, whose exports to the EU are dominated by energy products – CIS exports to the EU will probably be little affected by the increase of Central European exports to the EU, given that the CIS’s current share of EU imports is negligible, while the diversion effects of any gains by Central Europe will accrue far more to other developing countries. The level of development is clearly already significantly higher in Central Europe; per capita GDP in Central Europe stands at well over $3000 compared with $2000 in the CIS countries. While this difference is too small to imply a different structure of comparative advantage, evidence that will be presented in the next section shows that Central Europe indeed enjoys a different comparative advantage, with less focus on natural resources and even less on agricultural goods. Furthermore integration is likely to sharpen these differences because of the boost to growth for Central Europe and the greatly increased opportunities for intra-industry trade.4 Winters (1997) summarizes the literature on third-party effects and concludes that integration will have negative effects on third parties; however these effects are likely to be small unless the countries in question are highly dependent on the integrating bloc. For the CIS countries as a group, export dependence is moderately high, but not excessively so, at 27.7 per cent. Only three countries display such high ratios: Armenia, Kazakhstan and Russia. Of course data on CIS exports are prone to substantial statistical difficulties, including undervaluation of exports (especially to non-CIS destinations), barter trade valuation and the like. The export shares shown would, however, have to be substantially underestimated if they were to change the qualitative conclusion on dependence. This issue can be viewed in another way: for most CIS countries the current shares of exports to the EU are not yet at the new post-Soviet equilibrium, as Havrylyshyn and Al-Atrash (1999) argue. Having progressed much farther with their reforms than the CIS countries, the countries of Central Europe have diversified their exports far more in line with EU reforms. In short, to the extent that reforms will continue to progress in the CIS countries, their share of exports to non-CIS destinations, including the EU, will increase in the future. The above assertion is borne out by the size of the CIS countries’ trade balance vis-à-vis the EU (Table 13.2). With the exception of Kazakhstan, Russia and Tajikistan, it is not only negative but also quite substantial, ranging from nearly 10 per cent of exports to as much as 80 per cent. Its relevance is noted by Winters (1997): a non-integrating partner can gain from declines in EU export prices if it has a large trade deficit with the EU. Of course the continuation of such large trade deficits will depend on continued capital

Table 13.2 Trade flows, CIS, Baltic and CEE countries, 2001

World (In million US dollors) Armenia 341.8 Azerbaijan 2 314.1 Belarus 7 428.3 Georgia 570.8 Kazakhstan 8 646.8 Kyrgyz Republic 476.1 Moldova 570.1 Russia 82 535.1 Tajikistan 651.6 Turkmenistan 1 132.4 Ukraine 14 615.4 Uzbekistan 2 024.7 Total 121 307.2

EU

CEEC-7 ⫹ Baltics

Other CIS

88.3 1 608 821.5 235.4 2 014.9 117.5 122.2 31 976.2 213.5 128.5 2 969.7 428.4 40 724.1

1.5 18.5 1 317.8 10.3 264 9.8 61.1 14 581.5 53.6 58.7 1 794.8 179.4 18 351.0

87.7 222.9 4 472 134.2 2 632.2 168.7 346.8 8 588.1 211.5 501 4 416.2 1 038.3 22 819.6

Imports from EU

251.7 273.7 1 242.2 264.2 1 507.6 54.6 249 14 865.1 41.5 250.9 4 869.6 522 24 392.1

(In per cent)1 Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgyz Republic Moldova Russia Tajikistan Turkmenistan Ukraine Uzbekistan Total

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

25.8 69.5 11.1 41.2 23.3 24.7 21.4 38.7 32.8 11.3 20.3 21.2 33.6

0.4 0.8 17.7 1.8 3.1 2.1 10.7 17.7 8.2 5.2 12.3 8.9 15.1

25.7 9.6 60.2 23.5 30.4 35.4 60.8 10.4 32.5 44.2 30.2 51.3 18.8

– – – – – – – – – – – – –

CEEC-7 ⫹ Baltics

100.0

67.2

13.7

4.8

–

Note 1. Trade balance with the EU as a percentage of exports to the EU. Sources: Directions of Trade Statistics; WIIW.

Trade balance with EU1 ⫺163.4 1 334.3 ⫺420.7 ⫺28.8 507.3 62.9 ⫺126.8 17 111.1 172 ⫺122.4 ⫺1 899.9 ⫺93.6 16 332.0 ⫺185.1 83.0 ⫺51.2 ⫺12.2 25.2 53.5 ⫺103.8 53.5 80.6 ⫺95.3 ⫺64.0 ⫺21.8 – –

Exports to EU as % of EU imports

– – – – – – – – – – – – – 0.004 0.072 0.037 0.010 0.090 0.005 0.005 1.423 0.009 0.006 0.132 0.019 1.812 4.462

350

Exports to:

Oleh Havrylyshyn 351

flows to the CIS countries, particularly foreign direct investment, which may itself be negatively affected by the non-accession of those countries.

Trade effects Baldwin et al. (1997) have thoroughly assessed the costs and benefits of EU eastward enlargement using a Computable General Equilibrium (CGE) simulation model to estimate trade effects and income changes, as well as induced investment-cum-efficiency improvement effects. As is customary in such exercises the focus is on the integrating partners, not third-party partners, although the authors do provide an estimate of real income changes for the former Soviet Union, with an income gain of 0.3–0.6 per cent compared with 1.5–18.8 per cent for the CEEC-7 (see Table 13.1). No explanation is given for the former Soviet Union estimate, but the estimates for the integrating group provide a starting point for some simpler partial equilibrium calculations of trade-diversion and trade-creation effects on the CIS countries. Trade-diversion effects as a percentage of CIS exports (CISTD) can be defined as follows: CISTD ⫽ ⫺CEGAIN (CEXP/CISEXP) ⫻ [CISEUSH/(CISEUSH ⫹ DCEUSH)]

(13.1)

where CEGAIN is the percentage increase in Central European exports as a consequence of accession, CEEXP/CISEXP is the ratio of Central Europe to the CIS in EU imports, CISEUSH is the CIS’s share of total imports by the EU, and DCEUSH is the share of other developing countries in total EU imports. Equation 13.1 assumes that in the first round the effect of CEGAIN is a loss to its direct competitors: the CIS and other developing countries. As a first approximation it seems reasonable to assume that industrialized countries outside the EU do not compete with Central Europe; however if they do the equation is biased towards a higher estimate of trade diversion. The ratio in square brackets reflects another first approximation based on the assumption that developing countries and the CIS share the trade diversion loss in proportion to their current shares in EU markets. Some of these assumptions are explored below, together with appropriate modifications of the estimate. A value for CEGAIN is taken from Baldwin et al. (1997), who, when presenting a conservative case where income gain is a relatively modest 1.5 per cent, report an increase in exports of 25 per cent. Their less conservative estimate shows a huge income gain of 18.8 per cent. Most of that gain, however, could come from efficiency improvements, with an estimated increase in capital stocks of 68 per cent, while export expansion (which they do not report) would not be very much higher. Let us assume it is 30 per cent in order to provide an upward bias to the trade diversion estimate. The values for CEEXP, CISEXP, CISEUSH and DCEUSH are taken

352 The Impact of EU Enlargement on Outside Countries

from Table 13.2, the resulting estimate being CISTD ⫽ 30%(2.46) ⫻ [1.8/(1.8 ⫹ 17.2)] CISTD ⫽ 7%

(13.2)

In summary, partial equilibrium sets an upper limit to the trade-diversion loss, estimated at 7 per cent of exports. This is not a high figure because the ratio in the square brackets is very low at 0.095: it can be interpreted as the proportion of CIS exports in all exports to the EU that compete with those from Central Europe, which thus lose from trade diversion. This estimate represents an upper limit for three reasons: ●

●

●

Only the CIS and other developing countries are assumed to lose from Central Europe’s gains – industrialized countries do not. The CIS and other developing countries are direct competitors with similar comparative advantages. The CIS and Central Europe are direct competitors with similar comparative advantages.

If we accept that some of the trade diversion loss is borne by industrial country exports, this lessens the effect on the CIS (chemicals and metallurgical products may be one such area). In order to obtain an idea of the possible magnitude, let us suppose, quite arbitrarily, that of the remaining 81 per cent of EU imports not included in the denominator in the square brackets, 5 per cent are also competing with Central Europe, hence it too loses from trade diversion. If we call this ICEUSH (⫽ 5.0) and add it to the denominator in the square brackets in Equation 13.1 (1.8 ⫹ 17.2 ⫹ 5.0), it follows that the proportion of CIS exports to the EU in all EU exports that are considered to compete with Central Europe drops even further, from 0.095 to 0.075, while the CISTD estimate drops to 5.5 per cent. CISTD* ⫽ 30%(2.46) ⫻ [1.8/(1.8 ⫹ 17.2 ⫹ 5.0)] CISTD* ⫽ 5.5%

(13.3)

From Table 13.3 we can see that the structure of CIS exports to the EU is far more oriented towards raw materials and agriculture than that of Central Europe. In order to reflect this partial competitiveness with other developing countries (especially in the field of manufactures), one can arbitrarily reduce the ratio in square brackets to 0.65, for example, which has the effect of reducing CISTD to 4.8 per cent. Finally, approximately 40 per cent of CIS exports (raw materials) are likely to suffer little or no trade diversion losses. Thus Equation 13.1 should be thought of as being applicable only to the remaining 60 per cent of manufactures and agricultural goods. Hence TOTCISTD ⫽ 0.4(ZERO) ⫹ 0.6(CISTD) ⫽ 0.6(4.8) ⫽ 2.9%

(13.4)

Oleh Havrylyshyn 353 Table 13.3 Product composition of exports to the EU, 2000, SITC 1 digit product codes, percentage of EU imports from each country1 0

1

2

3

Armenia 0.1 Azerbaijan 1.9 Belarus 4.2 Georgia 8.1 Kazakhstan 1.3 Kyrgyz Republic 0.2 Moldova 10.5 Russia 1.4 Tajikistan 0.0 Turkmenistan 0.0 Ukraine 3.1 Uzbekistan 0.2 CIS 1.6

0.1 0.0 0.0 3.2 0.0 0.0 0.2 0.1 0.0 0.0 0.3 0.0 0.1

6.2 1.0 15.1 12.2 2.2 4.7 19.5 6.4 51.4 20.8 25.7 53.6 8.0

0.0 94.6 6.8 55.7 72.0 0.0 0.0 65.4 0.0 68.0 9.7 0.8 60.9

Czech Republic Hungary Poland Slovakia Slovenia Bulgaria Romania Estonia Latvia Lithuania CEEC-7 ⫹ Baltics

0.5 0.3 0.1 0.1 0.1 2.0 0.2 0.0 0.2 0.0 0.3

4.2 2.1 2.2 1.5 3.1 5.4 3.3 3.4 2.5 0.0 5.8 2.1 4.5 0.4 13.0 21.4 28.3 33.5 15.2 13.4 4.5 4.1

1.2 4.1 5.4 0.9 0.9 3.6 1.9 2.1 1.4 5.5 3.1

4

5

6

7

8

9

0.0 0.2 0.0 0.2 0.0 12.9 0.0 4.7 0.0 2.4 0.0 0.2 0.0 0.3 0.0 4.9 0.0 0.0 0.0 0.4 0.4 9.7 0.0 0.8 0.0 4.9

87.6 0.5 23.2 4.5 20.6 1.3 21.1 19.0 35.9 8.8 27.6 20.7 19.3

1.6 0.7 9.8 6.5 0.5 0.6 1.8 1.2 0.2 1.5 5.4 0.9 1.6

2.7 0.3 26.8 4.6 0.1 0.2 46.3 0.8 12.4 0.3 16.9 0.2 2.3

1.4 0.8 1.1 0.5 1.0 92.8 0.2 0.8 0.0 0.2 1.2 22.9 1.3

0.0 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

23.4 10.0 24.4 21.7 26.6 34.1 16.6 13.4 17.9 15.2 19.9

49.4 64.0 34.9 49.8 41.2 9.2 18.4 33.0 2.7 10.8 42.6

13.6 12.5 21.4 15.5 22.7 35.2 54.6 15.0 14.7 29.6 20.2

1.0 0.6 0.6 0.5 1.1 0.7 0.4 0.1 0.5 0.7 0.7

4.7 4.9 4.6 4.8 4.7 7.2 3.0 1.9 1.0 9.6 4.6

Notes 1. SITC codes: 0 ⫽ food and live animals; 1 ⫽ beverages and tobacco; 2 ⫽ inedible, crude materials, except fuels; 3 ⫽ mineral fuels, lubricants and related materials; 4 ⫽ animal and vegetable oils, fats and waxes; 5 ⫽ chemicals and related products; 6 ⫽ manufactured goods; 7 ⫽ machinery and transport equipment; 8 ⫽ miscellaneous manufactured articles; 9 ⫽ goods not classified by kind. Source: WIIW.

If the 30 per cent gain for Central Europe is the weighted average for raw materials and others, and if the gain for raw materials is still positive but very small (in the order of 10 per cent), the gain for manufactures in Equation 13.1 will be 35 per cent and the resulting final adjustment estimate in Equation 13.4 assumes a value of 3.3 per cent. While relaxation of the direct competitiveness assumptions may be justified, any further paring down would be excessive. The result is a range of moderate but distinctly negative effects: a trade diversion loss from 2.9 per cent to 7.0 per cent. Trade creation would arise from the growth of the newly integrated partners: the original EU-15 plus Central Europe. The partial equilibrium estimate is quite straightforward: CISTC ⫽ CEGROW(CISCESH) ⫹ EUGROW(CISEUSH )

354 The Impact of EU Enlargement on Outside Countries

where CISTC is the growth of CIS exports through trade creation as markets expand, CEGROW and EUGROW are the income growth rates for Central Europe and the original EU-15 respectively, and the terms in brackets represent the shares of CIS exports in Central European imports and EU imports, respectively. We take the low- and high-case results on income growth from Baldwin et al. (1997) and the share values from Table 13.2: Low CISTC ⫽ 1.5(0.151) ⫹ 0.2(0.018) ⫽ 0.227 ⫹ 0.004 ⫽ 0.23

(13.5)

High CISTC ⫽ 18.8(0.151) ⫹ 0.2(0.018) ⫽ 2.838 ⫹ 0.004 ⫽ 2.84

(13.6)

At first sight Baldwin et al.’s low-case scenario seems extraordinarily conservative. They admit this, since the scenario does not include the significant effects of a reduced risk premium, which greatly increases the attractiveness of new members to investors. On the other hand their high-case scenario is unusually high for such exercises; for example it goes well beyond the range of estimates for the Mediterranean countries in the partnership agreement under the Barcelona process.5 The latter estimates – around 5–10 per cent – may in fact be lower than those for fully fledged accession cases. If one were to assume a median value of 10 per cent for Central Europe, the trade creation estimate for the CIS would be 1.54 per cent. It is notable that virtually all the trade creation would come from increased markets in Central Europe. This is not all that surprising. First, the growth effect of EU enlargement will be almost entirely to the benefit of the new members, and not to the EU-15, given the relative size of the economies in question (Table 13.1). Second, the size of the Central European markets should not be overlooked: even today, before high growth sets in, they are nearly as large in GDP terms as the CIS markets. Indeed a simple gravity model view would lead one to question whether in fact the 15.1 per cent share of CIS exports to Central Europe is well below the level of equilibrium diversification from the original intra-USSR trade patterns. If it were 20 per cent, the median-case estimate of CISTC would increase from 0.2 per cent to 0.3 per cent and the high-case estimate from 2.8 per cent to 3.8 per cent. Ignoring the low-case CISTC and taking the median case in its stead, the partial equilibrium estimates of trade effects are as follows (trade effects as a percentage of CIS exports): trade diversion, 2.9–7.0 per cent; trade creation, 1.54–3.8 per cent. If, for the sake of simplicity, one takes the difference between trade diversion and trade creation at each end of the range, the result is a net effect of ⫺1.36 per cent to ⫺3.20 per cent: in short the net impact may be negative, but it is very small. While this means that trade creation accounts for no

Oleh Havrylyshyn 355

more than 50–55 per cent of trade diversion, a net impact of well below 4 per cent is close enough to zero to allow a working hypothesis that tradediversion effects are to a large extent offset by trade-creation effects. The summary by Winters (1997) of previous studies on third-party effects gives further reason to accept this broad-brush conclusion. First, such studies generally conclude that direct effects are probably negative but generally very small, unless trade dependence is very close. Second, if third countries suffer a trade deficit (and Table 13.1 clearly shows that this is the case for most CIS countries), the possible benefits of lower import prices will outweigh the net trade effects. Recall that Baldwin et al. (1997) produced an income-change estimate for the former Soviet Union that was positive but low. Finally, as shown in Tables 13.1 and 13.2, it should be noted that Russia has the highest share of exports to the EU and Russia accounts for a disproportionate share of the 1.8 per cent import penetration of the EU, and that Russian exports are strongly biased towards raw materials. This comparative advantage implies a limited trade-diversion loss. For the rest of the CIS the very low import penetration (0.3 per cent for all CIS countries, excluding Russia) gives them a niche position that implies a limited threat to domestic producers and suggests that the real impact of trade diversion is probably smaller than previously estimated. A zero net effect hypothesis thus seems all the more warranted.

Effects on foreign direct investment The greatest benefits that will accrue to the new members from accession will probably derive from the increased flows of foreign direct investment (FDI) – or indeed from investment in general, including domestic investment. EU membership provides an anchor for good policy, and economic stability is perhaps the most important factor in attracting investment. Sachs (1993) emphasizes the significance of this anchor to Europe in his study of Poland’s ‘leap’ to a market economy. Baldwin et al. (1997) have also noted this and, as discussed earlier in this chapter, consider it to be of far greater benefit than trade expansion alone. Hoekman and Djankov (1996a) also stress the importance of the ‘anchor’ effect for Central Europe and – similarly but to a lesser degree – the Mediterranean partnership countries. Finally, Havrylyshyn (1997) describes the ‘beacon’ that the Mediterranean agreements could provide to attract foreign investors. In conclusion, whereas it is simple to deduce that accession will help the new members to attract FDI, it is difficult to determine whether this will ultimately imply an FDI diversion of some kind away from excluded countries. One should first consider the data on FDI in the two regions. Most striking is the enormous difference in per capita FDI: $449 billion goes to Central Europe (the potential accession group) and $87 billion to the CIS (the nonaccession group). While in GDP percentage terms the figures for the two

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regions are similar, this may be somewhat misleading. The average is unweighted and the figure for the CIS is dominated by extremely high energy-related investments in three countries: Azerbaijan, Kazakhstan and Turkmenistan. Since no Central and Eastern European accessions have yet occurred and are indeed many years away for countries that are not among the leading eight, one can assume that this phenomenon is related less to accession and more to two other factors: progress in transition reforms that create a climate conducive to FDI; and opportunities for natural resource exploitation. The present author has not undertaken a substantially new FDI analysis and has therefore not included all possible factors, particularly risk premia, which are difficult to measure. On the contrary he has endeavoured to illustrate the importance of EU accession by means of a few simple regressions using the following framework: FDIPC ⫽ a ⫹ b REF ⫹ c DEU ⫹ d DOG

(13.7)

where FDIPC is cumulative foreign direct investment per capita, REF is the EBRD reform index, DEU is a dummy for EU accession (0 for the CIS, 1 for the others) and DOG is a dummy for oil and gas resources (1 for Azerbaijan, Kazakhstan, Turkmenistan and Russia, 0 for the others). One would expect reforms to have a positive effect in respect of attracting FDI. In his study on FDI in Central Europe, Estrin (1997) emphasizes this factor, while in their analysis of growth performance in transition Havrylyshyn et al. (1999) have found very strong evidence to support the hypothesis that reforms ultimately yield a better growth performance, which in turn attracts FDI. For example they note that for Central European countries that in the early 1990s enjoyed sustained growth for a period of three years or more, in 1996 per capita FDI stood at about $70, whereas countries that experienced late growth or no growth at all had much lower levels of around $10. The anchoring or beacon effect noted earlier suggests a positive coefficient for the accession dummy even in advance of accession. For natural resources, standard FDI theory (see Froot, 1994) and the special case of transition (see Estrin, 1997) tell the same story of FDI attraction, that is, a positive DOG coefficient. This raises questions about a variable that has been excluded: special incentive policies designed to attract FDI. Apart from the difficulty of measuring this variable consistently for these countries, the standard conclusion in the literature, as repeated in the case of transition countries by Estrin (ibid., p. 21), is that ‘when the economic environment is not stable [which presumably is the case in the early stage of the transition period] commitment to reform becomes important, while the role of specific investment incentives is open to debate’, and these ‘incentives may not in fact be particularly important in motivating FDI into [Central Europe]’. What, if anything, can be said about the difficult aspects of these issues: may it be assumed that countries that do not accede will lose out on future FDI, all other things being equal? The answer to this question may depend

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on the counterfactual. If the argument is that with Central European countries acceding and CIS countries not, some FDI diversion will almost certainly occur, although it is unlikely to be one to one since the pool of FDI supply is not fixed. The economics of attracting FDI to the new accession countries will be based on a reduction in the risk premium for investors. Given any elasticity in the FDI supply curve, accession will do more than divert FDI from non-accession to accession economies: there will be an increase in the total FDI to the two regions compared with the counterfactual of neither group acceding. Furthermore three factors will ensure that significant amounts of FDI will continue to flow to the CIS. First, natural resource exploitation will remain fairly independent of any accession or even major market reforms. One only has to think of Zaire and Nigeria – obviously it takes serious political and civil turmoil to stop or reverse FDI in natural resources. Second, some of these economies have large domestic markets that are far from satisfied with post-Soviet goods and services, so foreign investors will still step in to cater to domestic demands in Ukraine, Kazakhstan, Uzbekistan and Russia. However, some losses may occur to Central Europe as CIS markets could be supplied from platforms in the new EU (the Baltic countries, Poland, Slovakia and so on). Third, FDI from Central Europe to the CIS is likely to increase. Finally, when the Central European countries accede the CIS countries will be under tremendous pressure to improve their economies and markets to attract FDI. The weak results of the reform variable in the above regression notwithstanding, improved reforms may still be the best way to compensate for non-accession. One is tempted to recall the old story of Avis versus Hertz. As number two in the car rental market, Avis openly admitted to the fact and conducted a long-term campaign based on the slogan ‘We try harder’. While Avis failed to displace Hertz as number one, it is still around and thriving. Faced with the unlikelihood of accession in the foreseeable future, the CIS countries will simply have to try harder at economic reform.

Labour and human capital flows The least quantifiable effects, the flows of labour and human capital, may paradoxically be the most important for the non-accession countries. In principle labour flows are measurable and consist of temporary workers who will presumably provide benefits to their home country in two forms: remittances during their absence and acquired human capital upon their return. Neither theoretical nor statistical information is available to permit an assessment of the degree to which this has actually been happening, let alone to assess any likely changes. Short-term flows complicate the story and are even more difficult to evaluate6 as they take so many forms: experts from developed countries spending time in developing (or transition) countries,

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temporary workers returning, students and academics, and temporary professional visitors; indeed even tourists/visitors bring back human capital a drop at a time. To appreciate the last point, one need only recall how frequently it has been said that Poland’s success is due to the fact that its relatively loose travel restrictions in the 1980s helped to create a populace that was aware of and pining for a market economy. In the absence of a sound theoretical framework or a database for analysing the matter, can anything be said? One short-cut may be to proceed from the following proposition: the transfer of human capital is positively related to the volume of transborder contacts. If this is accepted as reasonable, the following question may be asked: is there anything about the accession of the Central European countries that could affect the flow of persons from the CIS countries via permanent migration, temporary work or for professional/tourist purposes? At this juncture it is difficult to predict the degree to which general policies towards permanent or temporary migrants will change, but the one factor that may play a role is the application of the Schengen regulations. The magnitude of permanent flows to the EU has not been huge, although in comparison with the near zero values in the preceding 40 years the migration in 1996 of 32 000 persons from Russia to Germany appears a large number (OECD, 1998, chart 1.3). It may be expected that the number of illegal immigrants or transit migrants from Central Europe will add considerably to the above figure. Total illegal immigration in Europe is said to be in the order of two to five million (ibid.). The Schengen regulations may not affect direct flows to the present EU countries, but they are likely to curtail sharply the flows to Central Europe, where visa-free travel or easy-visa policies for CIS nationals prevail. This will in turn serve to curtail transit flows to Western Europe. As Emerson (1998, p. 12) states, ‘application of the Schengen rules to the accession candidates … will introduce new visa frontiers on the future frontiers of the enlarged EU’. Indeed this may begin to happen before accession, just as other EU acquis communautaire elements will have to be introduced in advance. While Emerson does not link the Schengen rules and regulations to barriers to human capital flows, it is clear that he views their introduction as a less than salutary move that calls for a rethink. An additional negative effect may be a further tightening of immigration and visa policies by the EU-15 in respect of the CIS countries, particularly in the case of temporary workers. With the accession of a population of some 65 million in the first wave and perhaps another 30–35 million in subsequent waves, the supply of low- to medium-skilled labour in the EU will be greatly augmented. Clearly the demand for temporary labour from countries outside the expanded EU will be substantially reduced. It may not be an exaggeration to speak of a new ‘visa curtain’ descending on the easternmost countries of Europe, delineating a new frontier nolens volens.

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One could ask whether positive effects are possible. Some new demand may be created in Central Europe as its labour force moves upstream and westwards, and as its GDP expands with integration. Nonetheless the Schengen rules and regulations will offset that effect, or at least partially. One is hard put to identify other potentially positive effects on population and human capital flows from the CIS countries that could be attributed to the accession of Central Europe per se. Human capital theory and migration theory can be drawn upon to substantiate the claim that any brain drain would be reduced by the ‘Schengen Curtain’. Thus, paradoxically, application of these rules and regulations would be good for those countries that lie beyond the new frontier. One may be revealing one’s own biases, but it is difficult to accept the notion that on balance the unregulated movement of people is a good thing. It is of course possible that EU politicians will recognize that any accession that leaves certain countries outside the new frontiers should be accompanied by new forms of cooperation with those countries. Indeed initiatives such as the Barcelona process for the Mediterranean countries and other initiatives detailed in Emerson (1998) may already reflect such thinking. The TRACECA project for building a transport corridor from Europe to Asia is yet another initiative. The extent of the compensatory effect that such initiatives will have is anybody’s guess, but it is not unreasonable to expect that their benefits will fall short of the potential benefits of accession.

Conclusions It is not easy to estimate the potential benefits and costs of EU enlargement for the old and new members (the EU-15 and Central European countries) because the largest benefits are likely to be related to investment and efficiency rather than a simple balance between trade diversion and trade creation. It is even more difficult to estimate the effects on countries that will not be included, particularly those in the CIS. One can identify three key channels of economic interchange through which positive and negative effects might be felt: trade flows, capital flows (particularly investment) and labour plus human capital flows. For trade flows, some simple partial equilibrium approximations have been calculated (based on the findings of Baldwin et al., 1997), which indicate that exports from Central Europe will increase by 25 per cent or more as a result of accession. The resulting trade-diversion loss to the CIS countries is likely to be between 2.9 per cent and 7.0 per cent of CIS exports. Trade creation for the CIS countries will be almost entirely due to the growth of the Central European economies, in the order of 1.5–3.8 per cent of exports. Thus on balance a small net loss will accrue, ranging from about ⫺1.36 per cent to ⫺3.2 per cent of exports. Being close enough to zero and given the imperfect data and methodology, it can thus be concluded that

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the trade-diversion losses will be largely offset by trade-creation gains. It should be noted that this corresponds closely to the common conclusion drawn for third-country effects in earlier studies – that is, that integration harms third parties, although the net magnitude is very small. With regard to investment flows, any estimate of the effects of these would require a heavy-duty, computable, general equilibrium exercise that has not yet been attempted. However some simple regression experiments with FDI flows to transition countries in recent years strongly support the ‘beacon’ hypothesis: EU accession is an extremely important determinant of variations in FDI flows across countries, quite independently of (and perhaps dominating) domestic reforms. While an FDI gain for those which accede is unlikely to constitute a one-to-one loss for those which do not accede, this does not mean that the non-acceding countries will not suffer, and the impact of this may well be much worse than that from the net trade-diversion effect. It also indicates that the CIS countries need to try even harder to introduce market reforms that will provide a stable and attractive investment environment. In order to assess labour and human capital flows, one is obliged to fall back on purely qualitative (and indeed speculative) analyses. In the future general policies on migration, temporary labour and other visa regimes may well change in response to forces other than accession, but consideration must be given to how Central European accession might affect such policies. One consequence could be a reduced demand for temporary labour from the CIS countries as the supply of low- to medium-skilled labour will greatly increase with the accession of the new members. This could be mitigated by a demand for such labour in Central Europe, although the effect would not be significant. The greatest risk comes from the imposition of the Schengen rules and regulations, which will introduce new and stricter visa restrictions on countries to the east of Central Europe. The effect of this may be subtle, and it may be offset by changes in individual EU countries’ policies on visa requirements, but for societies that in 1990–91 began to enjoy the freedom to travel after 50 years (or 70 in many cases) of being shut behind closed borders, even a partial reversal of this freedom may well cause distress. In terms of economic impact, any reduction in the cross-border flow of people (especially from less developed to more developed countries) is likely to reduce the transfer of human capital. There is an irony in the findings for the three different channels: the effects that are more difficult to estimate may ultimately turn out to be the most harmful to the countries that are excluded from accession. Notes 1. The views expressed in this chapter are those of the author alone and do not reflect the views or position of the International Monetary Fund. I am grateful to Sheila Basset and Alessandro Rebucci for assistance with the analysis, Peggy Asante for help with bibliographical references and Joan Campayne for drafting.

Oleh Havrylyshyn 361 2. Emerson merely reports the existence of such circles as part of European perceptions and views, and does not advocate European expansion along these lines. 3. We use actual exchange rates rather than PPP, since the issues addressed – potential imports into these countries – are to do with trade rather than domestic activity. 4. Hoekman and Djankov (1996a) show that by 1995 Central Europe’s intra-industry trade had already risen sharply and was far above that of the CIS countries. 5. For a summary see Havrylyshyn (1997). 6. For example a search in the OECD’s annual Trends in International Migration and the journal International Migration yields very little; these publications provide no current information on legal flows from the individual CIS and other former Soviet countries, and contain no estimates of illegal migration.

References Baldwin, Richard E., Joseph P. Francois and Richard Portes (1997) ‘The Costs and Benefits of Eastern Enlargement: The Impact on the EU and Central Europe’, Economic Policy, vol. 24, pp. 127–76. Berrigan, John and Hervé Carré (1997) ‘Exchange Arrangements between the EU Countries in Eastern Europe, the Mediterranean and the CFA Zone’, in Paul Masson, Thomas Krueger and Bart Turtelboom (eds), EMU and the International Monetary System (Washington, DC: International Monetary Fund). Blanchard, Olivier, Kenneth Froot and Jeffrey Sachs (eds) (1994) The Transition in Eastern Europe, Vol. 2, Restructuring (Chicago, Ill.: University of Chicago Press). Emerson, Michael (1998) Redrawing the Map of Europe (London: Macmillan). Estrin, Saul (1997) Foreign Direct Investment in Central and Eastern Europe (London: Royal Institute of International Affairs). Froot, Kenneth A. (1994) ‘Foreign Direct Investment in Eastern Europe: Some Economic Considerations’, in O. J. Blanchard, K. A. Froot and J. D. Sachs (eds), The Transition in Eastern Europe (Chicago, Ill.: University of Chicago Press), pp. 293–318. Havrylyshyn, Oleh (1997) A Global Integration Strategy for Mediterranean Countries (Washington, DC: International Monetary Fund). Havrylyshyn, Oleh and Hassan Al-Atrash (1999) ‘Geographic Diversification of Trade in Transition Countries’, in Mario Bléjer and Marko Skreb (eds), Balance of Payments Exchange Rates, and Competitiveness in Transition Economies (Boston, Mass.: Kluwer). Havrylyshyn, Oleh, Thomas Wolf, Julian Berengaut, Marta Castello-Branco, Ron van Roden and Valerie Mercer-Blackman (1999) ‘Growth Experience in Transition Countries, 1990–98’, IMF Occasional Paper no. 184 (Washington, DC: International Monetary Fund). Hoekman, Bernard and Simeon Djankov (1996a) ‘Intra-Industry Trade, Foreign Direct Investment and the Reorientation of Eastern European Exports’, World Bank Policy Research Working Paper no. 1652 (Washington, DC: World Bank). Hoekman, Bernard and Simeon Djankov (1996b) ‘Catching Up with Eastern Europe? The European Union’s Mediterranean Free Trade Initiative’, World Bank Policy Research Working Paper no. 1562 (Washington, DC: World Bank). OECD (1998) Trends in International Migration (Paris: OECD). Sachs, Jeffrey (1993) Poland’s Jump to the Market Economy (Cambridge, Mass: MIT Press). Winters, L. Allan (1997) ‘What Can European Experience Teach Developing Countries About Integration?’, World Economy, vol. 20, pp. 889–912.

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Part VI Political and Economic Challenges

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14 Political and Economic Challenges Facing the ‘New Europe’: Contributions from Panel Discussions1 Helen Wallace As the members of the European Union (EU) engage with the Central and Eastern Europe countries (CEECs) in negotiations for their accession, the nature of the discussion on the EU side is altering. The implications of what is at stake are starting to be looked at more closely, the subject matter has become much more technically focused on the acquis communautaire, and the timetable for the negotiations and their completion has become less clear. This process contrasts with the picture of a European continent liberated from its East–West division, in which the political leadership of the EU might be the architects of a new European settlement. It is easy to identify the obstacles and barriers to a smooth process of enlargement and to envisage a multitude of issues that could ensnare the accession negotiations. It is somewhat harder to identify how the EU might make a success of eastward enlargement. Propositions to encourage success What seems important is to recall some of the factors that might help to make eastward enlargement a success for the applicants and an historic achievement for the EU. Hence this contribution sets out five propositions that might make for successful enlargement: ●

●

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Engage the CEEC applicants in full, not diluted, EU membership, thus making them participants in the ‘deep’ integration experiment that is distinct to the West European experience. Engage as many of the CEEC applicants as possible in full EU membership, since that would enable a larger rather than smaller number of the countries concerned to pass through the tunnel of transition and out the other side. Define the terms of accession in such a way as to allow the applicants some space to find their own trajectories of development and adjustment, that is, give the applicants a version of the ‘Irish option’.

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Devise a constructive ‘near abroad’ EU policy, with generous arrangements for countries lying to the east and south of the applicants that are likely to be accepted so as to (1) stabilize cross-border arrangements for the eastern boundaries of the enlarging EU, and (2) lay a firmer basis for future partnership and interdependence (contrast here the experiences of Ireland and Greece, of which more below). Reach an agreement sooner rather than later in order to increase certainty about the framework of new arrangements across the continent.

If all these propositions were accepted the result would be deep integration of a wide group of countries, with differentiation to meet individual country characteristics and a planned basis for relations with the EU’s new ‘near abroad’ to the east and south-east. Each proposition has its critics, and there is evidence to suggest that the critics are winning some of the arguments. Hence there is a possibility that the propositions might be reversed and produce a quite different outcome. We shall consider each proposition in turn. First, the notion that deep integration should be a prime objective stems from an analysis of West European integration that includes three interlocking dimensions: functional or economic, territorial, and affiliational. The accession negotiations concentrate on the functional and economic alignment of candidates to the incumbent members’ policy regimes, and pay little attention to the territorial and affiliational dimensions of integration. Moreover the concentration on functional issues can cause problems in the other two dimensions. Second, which candidate countries are likely to be included as members? The EU policy makers’ preference has veered towards a smaller – and therefore ‘more manageable’ – number. The default preference is likely to be to drop candidates from the list rather than to lengthen the list. Third, there is an inherent rigidity in the accession negotiations as they are predicated on the assumption of asymmetrical alignment to an allegedly uniform acquis, with applicants being pressured to accept established EU policy templates even if it does not fit their circumstances well. The proliferation of EU legislation is invasive in the sense that it diminishes the countries’ scope for finding their own models of adjustment. Here the ‘Irish option’ needs to be noted: Ireland has used policy space not occupied by EU regimes to develop specific national policies that encourage socioeconomic modernization and innovative investment (both human and entrepreneurial). It is hard to discern traces of the lessons from this experience in the accession negotiations with the CEEC candidates. Fourth, the EU still lacks a ‘near abroad’ policy. Such a policy would have to comprise three elements: predictable partnerships with the candidates that are Europe associates but not yet fully involved in accession negotiations; a framework for dealing with other, especially south-eastern, European countries that are not yet able to make a credible application for

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EU membership; and at least a medium-term policy towards countries that are likely to lie beyond the eastern border of the EU for the foreseeable future. Some bits and pieces are in place for all three elements, and the Vienna European Council of December 1998 expressed a series of ‘must do better’ statements of intent. It remains to be seen whether a coherent policy can be articulated and operated. Fifth, with regard to the timetable for eastward enlargement, the pressures for extending this timetable seem to be much stronger than those for reducing it. Accession negotiations in themselves tend to bring reluctant enlargers more readily into play than is the case with enthusiasts. The eastward enlargement presupposes more intra-EU policy reform than any previous enlargement. Despite the efforts of some to downplay the budgetary costs, nervousness about recasting the EU budget, compounded by arguments about the net contributions of the existing member states, could well be a powerful delaying factor. Thus it seems that the success-inducing propositions might be too demanding – for two reasons. Compliance with the full EU acquis is indeed a tough target for the CEE applicants, even for those that are making striking progress in terms of socioeconomic modernization. The success scenario, however, also demands a great deal of the incumbent EU members in terms of policy reform on the one hand and strategic capability on the other. Observations about previous experiences and the current context In order to shed light on the reasons for the above we need to explore the nature of the accession negotiations and the context in which the negotiations are taking place. Accession negotiations constitute a narrow channel to be navigated between preaccession and postaccession. As we have seen with the development of the Europe association formula, the range of topics for cooperation was not only defined by the acquis but also encompassed quite a broad range of areas of cooperation. Indeed the formal preaccession strategy devised by the European Commission and endorsed by EU member governments in the European Council made specific distinctions between those parts of the EU acquis that were of more immediate pertinence to the associates and those that were less so. For example a line was drawn between product standards and process standards. However this line has rapidly eroded as the accession negotiations have progressed. The narrow focus on the acquis makes the accession negotiations rather conservative and path-dependent. The difficulty of unscrambling previously established EU regimes has predisposed the EU negotiators to stay within the parameters of previous intra-EU negotiations. Applicants find it hard to make a credible and convincing case for divergence from the acquis except when there is a real constituency for their views within the EU membership or on issues where EU policy is fluid. In the previous enlargement the applicants had some areas of common cause with a number of existing members,

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for example on levels of environmental protection. As yet no such bridging coalition has emerged to help the CEECs. In any event, eastward enlargement has to jostle with other EU priorities. Internally this largely means economic and monetary union (EMU), which has become the priority of priorities because of its immense salience. Added to this is the new discussion on growth and employment, fostered by the turnouts of the electoral cycle in the EU countries. It is still too early to judge where this debate might lead, but it is not obvious that a focus on such topics will draw more attention to or result in more resources for the applicant CEECs. In addition the EU has a number of other external preoccupations, both close to home in the southern Mediterranean and with a range of other external partners. In several of the external relationships currently being recast – including the Euro-Mediterranean dialogue and redefinition of the Lomé Agreement with the African, Caribbean and Pacific countries – market access and the free movement of persons are quite important issues. The point here is that the CEEC applicants are seeking access to the privileges of EU membership at the same time as the EU is under pressure to be more generous to other partners on some identical issues. The political economy of bargaining over these questions may well lead to defensive lobbying. Perhaps more encouraging for the CEECs is the new discussion in the EU on defence and security issues. The recent willingness to consider more carefully just where collective European interests lie could work to the advantage of the CEECs. The debate offers scope for extending the discussion beyond narrowly defined political economy issues of accession. All in all, both earlier experiences and current preoccupations suggest that the process of eastward enlargement is highly vulnerable to distraction and subversion. It is easier to envisage the latter winning out than to predict a path to successful eastward enlargement on the basis of the ambitious propositions outlined above. Yet the EU has much at stake in the success of the process. As politicians from the CEECs like to point out, the costs of nonenlargement for the EU would be high. Tipping the balance in favour of successful enlargement Part of the problem with the enlargement process so far has been the gap between the EU side, as regime makers, and the CEEC side, as regime takers. Much depends on whether or not the EU chooses to press ahead and on the technical progress made by each of the CEECs towards the EU template. To tip the balance in favour of successful enlargement requires a clearer and sharper focus on the part of the EU, and it most certainly requires the CEECs to behave more strategically. There are several ways in which a more evenly weighted dialogue might develop. Shadows of the past versus shadows of the future The focus in the accession negotiations on alignment by the candidates to the acquis of the incumbents is a focus on the past achievements of the EU. Instead

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attention should be paid to the future in order to identify opportunities that could result from enlargement and collective interests that might be served. An emergent feature in the EU needs to be brought more into play to give a future-oriented dimension to the discussion. The EU is currently moving out of a period of legislative overdrive aimed at developing the Single Market into a new policy mode of benchmarking and peer review: a kind of OECD mode of policy concertation. The new agenda on growth and employment is set to be developed more by this new mode than by legislation. The mode would allow the candidate countries to be much more actively involved in policy debates than has been possible in the traditional areas of the acquis, and to acquire a voice without damaging the integrity of the EU membership codes. Asymmetry or reciprocity Accession negotiations are inherently asymmetrical: a process of one-way alignment. The current enlargement negotiations have brought to the table a large group of countries that are in the process of systemic transformation, whereas previous enlargements involved candidates whose political economy configurations were already similar. One fact that has been neglected thus far is that the CEECs have an acquis of their own, a shared patrimony and a set of overlapping interests that have yet to be given a place in the discussion. For example there is free movement of individuals among the CEECs, and this will be disrupted if accession takes place in waves. The restriction of movement across the Hungarian–Romanian border is one such example. Similarly there are legitimate, and in some cases economically dynamic, cross-border ventures between the CEECs and their eastern neighbours, such as between Poland and the Ukraine. The CEEC governments need to take some ownership of this acquis and develop propositions for a joint approach to identifying ways of achieving reciprocal arrangements between the existing EU countries, the CEECs and their other neighbours. Hub-and-spoke or multilateralism The accession negotiations take place between individual EU governments and individual candidates. This hub-and-spoke method is a poor way of dealing with issues that concern the candidates as a whole. Moreover it is poor preparation for the multilateral reality of full EU membership. There are some signs that the candidate countries are beginning to concentrate more on shared concerns. Their governments are now less nervous about engaging in joint discussions than they were a few years ago when the EU’s suggestion that they work more together was interpreted as a danger signal. There is considerable scope for extended multilateral discussions among the CEECs on joint initiatives that could frame some of the discussions with the EU. Narrow or wide-angle lens? The accession negotiations use a narrow-angle lens to focus on a precise agenda. The mechanics of functional adaptation need to be balanced by a

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wider focus that takes other issues into consideration. Too much of the discussion on enlargement is about the mechanics of the transposition of the acquis to each of the CEECs, which was a major preoccupation in documents produced by the European Commission. However necessary this process is, it is only part of the story. It should be recognized that the EU discourse on these mechanics is profoundly aggravating to the CEECs, as well as deflecting attention from the wider issues involved. Here too the candidate countries need to find ways of broadening the scope of the discussion. In theory the European Conference is an instrument for doing precisely that, but in its early months it has yielded only slender results. Conclusion Eastward enlargement cannot be smoothly achieved and prove a success for both current and candidate EU members unless both sides take a firmer grip on the process. The EU is open to criticism for some of the obstacles it has laid in the path of enlargement, intentionally or otherwise. The current member states who favour enlargement need to inject more momentum into the process. It is not difficult to draw up a list of prescriptions for action on the EU side, but some of the momentum and some of the ideas should come from the candidate countries in order to demonstrate the salience of future opportunities, establish notions of reciprocity, make the process more multilateral and broaden the scope of the discussion. A shift in this direction would inject some political adrenaline into the dialogue. It might also help the governments of the candidate countries to engage their domestic constituencies in the process. ***

Erkki Liikanen Let us forget the mechanical details of EU enlargement and talk about visions. In principle negotiations are serious only when they are about resources, but with the end of the East–West division of Europe we have a unique opportunity to unify the continent in peacetime. Unfortunately, political pressures in some member countries have resulted in this being left off the agenda. What can be done to make enlargement a success? The first requirement is for the EU to reform its policies to facilitate full integration of the new member countries. Agricultural reform is not only important for the EU but is also a necessity for enlargement. If the EU does not move towards world market prices and liberalize its markets it will be in a very difficult situation. When the Central and East European countries join the EU the prices of their agricultural products will rise. The increased income from farming could deflect attention from the essential restructuring of these countries’ economies in favour of services and industry, and therefore it is clear that reform of the CAP is extremely important.

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Reform of the Structural Funds is also vital. The East European countries are far below the EU average as far as per capita GNP is concerned and funds should be liberated to redress this imbalance. The debate on the reform of basic policies will reveal whether the EU-15 are serious about this issue, and the way in which they deal with Agenda 2000 will be a serious test. If they do not do it in time, this will mean that enlargement is not really on the agenda. Moreover, as pointed out by Helen Wallace in the previous contribution, the EU must look to the future. What hard-core activities should be conducted at the European level? What are the areas in which Europe as a unit can do more than its member countries separately? This will require a clear definition of the areas in which optimal decision making can take place at the European level at a time when the EU is more heterogeneous than ever. In my opinion, decisions should be made at the European level to ensure homogeneity of the internal market. There is also need for a common competition policy, a joint policy for external economic relations and consolidation of EMU. In the other areas where EU policies actually complement the national policies the Commission must concentrate on programmes which are of European size, concentrate on projects that can be run really effectively. So this kind of concentration in all policy areas is the key challenge. Another key issue is institutional reform. If there is no efficient decision making, that will be the end of the European Union. Majority decision making must be instituted everywhere, otherwise decision making will become less efficient. A solution should also be found for the weighting of votes: this is already on the agenda but it must be tackled sooner rather than later so that there can be no excuse for impeding progress in the negotiations. With regard to the new member countries, the key challenge is to build societies that function well, not only in economic terms but also in respect of institutions, law enforcement and community law. This will not be an easy task and will require a combined effort. While the EU is ready to support applicant countries, it is the responsibility of each one to build up a properly functioning public administration and legal system. If the enlarged EU is to function effectively there must be mutual confidence that the law is being followed in the same way everywhere. The new countries must of course strengthen their economic base. The Commission follows that process very closely and does everything possible with the adjustment strategy. One needs to assess the size of the effort the member countries are ready to make. That should be translated into concrete programmes as soon as the decisions have been made and in a way that really strengthens the economic base of the countries in the areas where their relative position is weakest. They must be competitive in circumstances where the internal market rules prevail. Finally, the negotiations are a big challenge. Even though it is very difficult to go in detail through every piece of the acquis communautaire, it can be considered the best possible training programme for the applicant

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countries’ administration because there the Commission is partner. The Commission has a dual role to play. First, it has to guarantee that there will be some homogeneity of law even after the inclusion of the new member countries – otherwise the system cannot function. On the other hand, the new member countries should accede in a reasonably happy position. Reasonably happy, not fully but reasonably. This kind of balance, trying to guarantee the homogeneity of law – because the Commission is the guardian of the treaty – and, on the other hand, trying to help applicant countries in their efforts to be an equal partner when they join is very important work. One must go through this process chapter by chapter, piece by piece, because that creates its own logic which will lead to enlargement. Once community legislation has been adjusted, the pressure and its own dynamics in the Union will push for enlargement. The process of negotiation is important in this regard. One must not leave every single piece of common legislation outside these negotiations because then the whole issue disappears from the agenda. Thus visions are important to keep in mind all the time, but to keep the visions there must be movement every day. ***

Danuta Hübner The future of Europe abounds with challenges, and the way in which Europe and the Europeans respond to these challenges will shape the destiny of the new Europe. Three particular challenges are pan-European in character and therefore worth mentioning. The first is Europe’s diversity, which is a major obstacle to defining ‘Europe’. At the beginning of the 1990s there was a lively debate on Europe’s borders: the limits to Europe. However Europe cannot be defined geographically, nor indeed along linguistic, religious or ethnic lines. European history is one of contrasts – diversity and unity, continuity and change, great values and darkness, wonderful times and disasters – so any attempt to define Europe is an attempt in vain. Those who travel through Europe always come across places that claim to be at the heart of Europe and everywhere there are people who feel European. That is what matters and that is why the Iron Curtain was so absurd. With potential new members knocking at the door of the EU we have to remember that the new Europe must be the Europe of all those who feel European. Thus the major challenge is to build up and maintain the integrity and unity of Europe while preserving its diversity in every sense of the term, and moreover to make that diversity a source of power, competitiveness and change. The second challenge is related to EMU and enlargement, whose outcome will shape the Europe of the coming century. These two processes will generate – and have already started to do so – enormous pressure for change in every sphere of our lives. Enlargement is not just a technical exercise;

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rather it will bring about changes in many areas – in politics and security in the economy, and in the internal workings and policies of the EU. It will also bring about changes in thinking among the people whose countries are already members and those whose countries become members. There is no doubt that EMU presents a challenge to participants and nonparticipants alike, but over the years the EU has always had a remarkable ability to succeed and steadily progress against all odds. The immediate priority for policy makers is to secure the support, enthusiasm and understanding of the people of Europe for the course being charted. In this regard the quality of leadership in the EU and the individual European countries will be of crucial importance. The third challenge is to ensure that all those who have not yet participated in enlargement negotiations and are not within the accession framework are made to feel at home in the new Europe. This is a task not only for international bodies and organizations such as the EU, the ECE, the Central European Initiative, the Council of Europe and the OSCE but also for individual countries and all those who feel responsible for Europe and its people. ***

Loukas Tsoukalis The EU is faced with the difficult task of reconciling the deepening of integration with the accession of new members. While it has faced this task before, this time it is much more difficult. On the one hand monetary union is qualitatively very different from anything that has happened before in the context of European integration – arguably it is the most important event since the signing of the Treaty of Rome in 1957. On the other hand, both the number and the nature of the applicant countries make this round of enlargement totally different from the previous ones. We shall concentrate on three broad issues, that are likely to occupy prominent positions on the European agenda for several years to come. The first issue relates to macroeconomic policy. Economic and monetary union is, of course, about irrevocably fixed exchange rates, but it is also about the acceleration of political integration, monetary union being an instrument to achieve political ends. Monetary union should also be about restoring the role of macroeconomic policy at the European level, a role that has been largely lost at the national level. This particular dimension of monetary union did not become obvious until very recently due to the favourable economic environment that prevailed and the dominance of what is generally called economic orthodoxy (la pensée unique, as the French very appropriately call it). Recent changes in the economic and political environments have created a very different situation. The spread of financial crises in many of the emerging markets, coupled with the ups and downs of stock exchanges in

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the United States and the EU and the downward revision of economic forecasts, have raised questions about the effective coordination of fiscal policies at the European level and mix between monetary and fiscal policy. The interactions between conservative central bankers on the one hand and the economic and finance ministers on the other will be interesting to watch. The second issue refers to equity and redistribution, which have become an integral part of the European package deal, especially since the Single European Act of 1987 and the reform of the Structural Funds a year later. The redistributive role of structural policies has acquired major importance: net transfers to the poorest countries of the EU now constitute 3–4 per cent of their annual GDP, which is certainly not peanuts in macroeconomic terms. Over the next years, the enlarged EU will be negotiating the new financial perspectives for the period extending to the year 2006. It will also be negotiating the amounts of money to be spent and the new operating rules for the Structural Funds for the same period. A crucial question is how to avoid a further widening of the economic gap between countries and regions in Europe. In view of the imminent enlargement and the accession of countries whose levels of economic development are significantly lower than those of the poorest members of the EU, the concern about disparities should be placed in the context of a wider Europe. In EU jargon, how can the EU reconcile the interests of the ‘ins’, the ‘pre-ins’, and those who will have to remain in the waiting room for quite some years to come? There is another dimension of equity and redistribution that is likely to arise in the foreseeable future. In recent years, regional integration and globalization have produced an increasing number of losers: mostly people who find it difficult to adjust to rapid economic change. In most European countries this has been manifested in a rapid increase in unemployment; and in a few countries in increased income inequality. In virtually all member countries the losers tend to rally behind nationalist flags. Solving the problem of losers and potential losers in a time of rapid economic change will be difficult but essential for the EU, as failure to tackle the problem will have serious negative consequences for the process of European integration. The third issue relates to the legitimacy and accountability of European institutions. This is an important issue and one that will become even more important in the next few years. Over time there has been a widening of the gap between economic and political integration. In other words, while economic reality has become increasingly European and international, political reality has remained obstinately national with the EU institutions gaining legitimacy only indirectly through the nation states. Monetary union contributes to a further widening of the gap between economic and political integration. It will be interesting to see what happens when there is a recession in one of the major EU countries and the European Central Bank (ECB) decides to pursue a restrictive monetary policy. This problem is bound to arise sooner or later, given the heterogeneous character

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of the new currency area, and when it does the legitimacy of the actions of the ECB will be severely tested. Unless the EU tackles this problem quickly it will face very unpleasant repercussions. All three of the issues discussed above relate directly to enlargement. Rightly or wrongly the EU has given precedence to deepening over widening. The success or failure of deepening will determine the success (and speed) of the enlargement process. ***

Daniel Daianu Much of the debate on accession is localcentric or Eurocentric and we have a long way to go before we come to grips with what is going on in the world. It has been normal to focus the debate, particularly in the case of Central and Eastern Europe, on postcommunist transition. However in the early 1990s we were quite oblivious to the facts that Western Europe was itself going through hard times, that reform of the welfare state was called for, and that there was a need for greater flexibility and vitality in a world that was subject to the growing pressures of globalization and competition. Even the introduction of the euro has been interpreted by some as a ‘weapon’. The issue at stake is competition in the world. Moreover it is unclear what is going to happen in the years to come because the EU will have to deal with its own structural problems. Ironically the euphoria that followed the collapse of the Berlin Wall was accompanied by Euroscepticism in Western Europe, although one has to admit that bouts of Euroscepticism had been recurrent features along the path to European integration. For instance, it is salutary to recall the late 1960s, which were pertinently illustrated as a political mood by J. J. Servan Schreiber in his book Le Défi Américain (The American Challenge) or the 1980s, with the prevalent fear of Japan Inc. and the Asian Tigers. Another irony is that at the beginning of transition some figures in Central and Eastern Europe aired the idea of a dritter Weg (pace Zdenek Mlynar), only to be rejected quite justifiably by most politicians. But today many socialdemocratic governments in the West are searching for a ‘third way’ to preserve what are perceived as advantages of the ‘Continental model’ and so help address the impact of globalization and information technologies. It is questionable whether this search will influence enlargement. However it is certain that in most postcommunist countries many of the fundamentals of market-based systems are quite fragile and still require a lot of work. The growing reluctance of West Europeans to accept swift admissions is a reflection of the discrepancy between enlargement rhetoric and reality in the guise of pragmatic considerations. Policy makers calculate costs and benefits, and they need hard data to that end; it goes without saying that they

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are finding it very difficult to incorporate the soft variables of enlargement, such as the costs of non-enlargement. Their conclusions and decisions are thus skewed as they put to one side any factors that defy estimation, such as the political or geopolitical consequences of integration, which over the longer term will have an economic impact. To this conundrum one has to add the Balkan quagmire, which mirrors ghosts of times past and present, as well as the Europeans’ inability to find a way out of the impasse just as they are trying to achieve a united Europe. Europe needs to be embedded in the dynamics of the world. In this respect I wish to highlight the growing complexity of the world and its economy. I attach particular emphasis to the notion of complexity for to my mind both a psychological and a cognitive problem loom large. We have probably grown accustomed to a certain type of stability. It was set in the structures of the bipolar world and simple ideological confrontation, but it also displayed a sort of apparent linearity of technological progress. Today we inhabit a different environment marked by a trend towards a multipolar world, new information technologies that enhance globalization, the clash between integration and fragmentation and the occasionally violent ‘clash of civilizations’. We have difficulty digesting these phenomena analytically and responding to them operationally. In this context, mention has to be made of the globalization of financial markets and the resultant crippling financial crisis that has engulfed many emerging markets in Eastern Asia, Russia and elsewhere. Earlier signs of the financial ‘el niño’ were evident during the Mexican crisis in late 1994 and, quite revealingly, in the turbulence surrounding the Exchange Rate Mechanism in 1992–93. Many astute watchers and professional heavyweights are stunned by the swiftness of events and the spread of turmoil. Such terms as ‘irrational exuberance’ and ‘irrational stampede out’ are used to describe the functioning of large-scale and volatile capital movements, which leaves many questions unanswered and befuddle policy makers. More disturbingly they can lead to social and economic dislocations that given their proportions, are reminiscent of the Great Depression. One only has to think about the plight of tens of millions of people in Indonesia, or a few years earlier in Mexico after the dramatic fall of the peso. That is why we need to worry about these developments, formulate the right questions about what went wrong, and try to find correct policy responses. When addressing this state of affairs, greater humility is called for, including more intellectual self-scrutiny and honesty in dialogue, just as there is a need for more genuine leadership in policy making. Many claim that there is a leadership vacuum, thus explaining why no political solutions are ready at hand. But the London-based International Institute for Strategic Studies pointed to this vacuum back in the early 1990s, far ahead of the world financial crisis. Want of leadership thus seems to be a sign of the troubles

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governments encounter in our changing world, as well as of the difficulties they have in understanding and managing change. A major issue for debate is how we can reconcile increasing vulnerability to external shocks as a result of globalization with the almost congenital weakness of institutions in the emerging markets. Globalization of the financial markets can be viewed as an enormous financial innovation that is putting national environments under strain. We also know that financial innovation poses a threat to well-established market-based economies as well. Inferences are easy to draw. In Chapter 2 of this book George Kopits mentions something to which we probably do not pay sufficient attention: namely that for postcommunist countries, joining the EU overlaps to a large extent what they would have to do anyway in order to create market-based economies and democratic polities, or what Karl Popper called ‘open societies’. This has to happen irrespective of whether or not a postcommunist country decides to join the EU. Creating open societies is a much more complex and complicated process than is implied by price liberalization, privatization and economic opening. These buzzwords cannot capture the nature of institutional and cultural change or the strain on systems plagued by horrendous resource misallocation. Unless buttressed by change in the real economy and the workings of institutions, macroeconomic stabilization will be very short-lived. Four years ago Albania was hailed as a miracle, with a 4 per cent annual inflation rate. Seven to eight months ago Russia suffered an annual inflation rate of about 10 per cent. And we all saw what ultimately happened, against a backdrop of institutional disarray and barely sustainable policies. In both theory and political practice, insufficient attention has been paid to the magnitude of the resource reallocation required in postcommunist countries. Hence the importance that should be attached to the concept of strain. Likewise institutional change is what ultimately counts, and hocuspocus economics are out of place. Even restructuring hinges on the way in which institutions perform. In this regard, we need only think of corporate governance. One cannot go to a shop in Brussels or Washington and simply purchase an institution. Building up institutions is very much an organic process, although in postcommunist societies policy makers are condemned to be constructivist, seeking inspiration elsewhere and endeavouring to speed up processes. However reforms run the risk of focusing too much on the legalistic aspects of institutional change and neglecting its behavioural content. We thus have a dilemma. On the one hand the marginal cost of inaction becomes prohibitive, making speed so very important. For example it is questionable whether stabilization can be sustained unless the real economy is substantially restructured. On the other hand profound restructuring is not only very difficult and painful to achieve, it is also time-consuming. For years Western governments have tinkered on the fringes, incapable of

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making relatively minor adjustments. As already mentioned, the magnitude of resource reallocation required in postcommunist countries is quite enormous, and this explains why restructuring is so painful. Hence there is a strong argument for policies that encourage capital inflows, particularly foreign direct investment. It could be suggested that, aside from policy consistency and a sense of direction, the transition countries that have produced the best results have done so because of their better initial conditions (legacies of the past, including partial reforms) and their geographic proximity to the EU. Is it not striking that there should be a cluster of ‘front runners’ in close proximity to the EU? The investments and foreign capital that poured into those countries were prompted by the policies pursued by their governments. But clearly there was also a set of initial circumstances that favoured good results. Of great concern is that for most of the countries that are lagging behind and those on the periphery of Europe, a path-dependency has been developing that will hamper them for a long time to come. The ideological and political differences that divided Europe prior to 1989 are being replaced by new divides with an essentially economic dimension. Dariusz Rosati refers to this emerging divide in Chapter 11, and others have voiced similar concerns. Unless clever decisions are taken by political leaders the unification of Europe – in the sense of the ‘economic inclusion’ (to use a term much in vogue among the politicians of Europe) of most of the postcommunist countries – will remain but a distant dream. One also has to consider the implications for the citizens of the countries that are lagging behind: their feeling that they are excluded from the ‘clubs’ of Europe may serve to accentuate their sense of disappointment and identity crisis. In order to overcome this new divide, vision needs to be matched by a strategy that combines a greater commitment by Brussels (that is, by the EU governments) with the domestic reform efforts of the candidate countries. The EU governments have to labour on three discrete fronts: working at home, reforming the EU (the Common Agricultural Policy, regional development and so on), and maintaining an international dialogue. All these fronts will have a direct or indirect impact on enlargement. Governments in Central and Eastern Europe have to persist with their structural reforms in order to build up institutions and strengthen their financial systems. There is a need to nurture the development of a strong middle class, a solid civil society, as the backbone of a functioning market economy and democracy. If citizens do not feel economically and politically empowered, friction will be unavoidable and energy will not be put into improving economic performance. It will thus make sense to think about the type of capitalism that is in the making in postcommunist Europe as the answer to this question will have relevance for the enlargement issue. From the standpoint of the political economy of the process, the dialogue on enlargement poses a major question. How can people in the West be put

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at ease with respect to facilitating the process of enlargement? Ultimately Brussels will not decide on the speed and pace of admission, national governments will – governments that are accountable to their electorates. If Western citizens feel uncomfortable about new entrants, if they think that this will increase structural unemployment, politically articulate interest groups will not be slow to voice these anxieties. I am not among those who advocate very rapid admission, irrespective of the costs on both sides. Rather I am in favour of realism and enlightened pragmatism, acknowledging the various constraints on rapid enlargement but also cautioning against losing both sight of the target and momentum. We all have a stake in forging a true partnership and making it work. It should be emphasized once more that European dynamics cannot be divorced from developments in the world economy. There is so much turmoil throughout the world that many knowledgeable people are asking for a revision of the architecture of the international economic system to replace the Bretton Woods structures. Whatever emerges from the current endeavours, the international system will have to address the increased vulnerability of those countries which are less able to weather external shocks. And therein lies a joint paradox and irony. Those which are more likely to have to brace themselves to deal with the volatility of large capital movements are less capable of doing so because they have fragile institutions and structures; solid institutions cannot be created overnight. On a more general note, if the world economy does not develop a dynamic to prevent the EU from becoming still more protectionist and turning into an isolated fortress that diverts trade (in a world of trading blocs), it will be difficult to effect a swift and smooth admission process. ***

András Inotai There are four sets of challenges that we shall address very briefly here: the global challenges that each and every country in the world is facing; internal challenges in the European Union; internal challenges in the transition countries of Central and Eastern Europe; and challenges in the relations between the EU and the countries of Central and Eastern Europe. Looking first at the world economy, it is not clear how far Europe has progressed in catching up with global technological competition. Moreover the manner in which Europe faces the risk of declining growth will be of fundamental importance. If Europe were to assume economic leadership it could make an important contribution to the world economy, but is it capable of doing so and would it be willing to assume the role? Here, very clear political leadership will be needed. We shall now consider a few of the internal challenges faced by the EU. Considerable progress has been made in the integration process over

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the past decade, but outdated policies still prevail and cannot be financed or maintained because of external pressure. The Common Agricultural Policy is a case in point. In some areas, such as institutional reform and financial issues, the EU has virtually become a victim of its own success. If it had not been successful it would not have 15 members today, nor would so many other countries wish to join it. Then of course there are the global challenges that are expected to arise from European Monetary Union. Finally, an issue that is seldom addressed is the question of generational change in Europe. At the present time, those with personal experience of the Second World War and who designed the architecture of the new Europe, including the integration framework, are stepping down for obvious reasons and a new generation is now coming to the fore. How will this new generation treat their legacy? Will they treat it in much the same way as their predecessors did, or will they shape it differently? These are questions that cannot be answered in economic terms. With regard to the challenges facing the countries of Central and Eastern Europe, three in particular come to mind. First, within the span of a single generation these countries have been confronted with the unprecedented challenge of having to adjust to radical political, economic and social changes. Moreover they are now facing the challenge of adjusting to the EU (which has been the external modernization anchor for all of them) and of finding an adequate response to global challenges. Second, there is the vital question of whether the economic progress they have made is sustainable. Over the years we have seen macroeconomic figures that on the surface have appeared very healthy but turned out to be unsustainable. One of the fundamental lessons of transformation is that macroeconomic stability cannot be maintained unless it is based on sound microeconomic foundations. Two processes are in train in Central and Eastern Europe: the so-called ‘transformation’ or ‘stabilization process’, and the ‘sustainable growth’ or ‘sustainable modernization process’. At present very few countries can be decisively placed in the second group. Most of them are still trying to catch up, and the question of whether they will be successful remains open. Third, while the institutional absorption capacity of the transforming countries has to be addressed, their institutional frameworks and degree of cooperative behaviour may be more problematic. Hence this is basically an issue of mentality and the extent to which these countries will be able to adjust to the requirements of the EU. The final set of challenges concerns relations between the EU and Central and Eastern Europe. First, the next enlargement will be the first to take place in a global framework. Therefore a major question about enlargement is whether, and the extent to which, eastward enlargement will help to strengthen Europe’s position in international politics and the global marketplace. Unfortunately this important issue has not been given sufficient attention.

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Second, a ‘contractual gap’ in the Association Agreements is reflected in the rapidly growing trade deficit of most countries in Central and Eastern Europe. Between 1992 and 1997, 83 per cent of the EU’s accumulated world trade surplus came from the 10 countries of Central and Eastern Europe, while these countries accounted for only 7–8 per cent of the EU total extraregional trade. In absolute figures the deficit amounted to ECU67 billion. If we assume that, on average, ECU40 000 is needed to create a job the EU trade surplus created or maintained 1.6 million jobs in Western Europe. This has never been mentioned in any discussion of the impact on the labour market of the opening up of the economies of Central and Eastern Europe and their accession to the EU. While job security is a very important issue we have to remember that the more a country restricts the flow of labour, the more capital is likely to move out of that country. Capital flows are global, while employment and jobs are national and partly regional concerns. Third, the Schengen Agreement is important politically and strategically. All the new member countries will have to take part in it and this will strengthen the security of all those involved. However at the same time a security loss may be incurred along the new Schengen borders as long as the loss is greater than the gain the stability of the whole of Europe may be in question. Therefore we have to be very careful about how we shape the future structure of the enlarged EU. As a final remark, everybody in Europe is facing a very important educational challenge. We have to create a new European identity, a new vision in the global market place; we have to find our place in a knowledge-based society where social and institutional flexibility will be very important elements in international competitiveness. And in this context we have to shape public opinion. In general members of the public in the EU-15 have no idea whether negative impacts on the economy derive from the planned enlargement of the EU or from other sources. Similarly the people of Central and Eastern Europe do not know whether negative impacts on their economies and everyday lives are due to their countries’ preparations to join the EU. We have to make clear those factors which are actually linked to accession/enlargement and those which are linked to global, domestic and other factors. We need a vision that is based on the future and not on preserving the status quo. This educational task should be made a core element of our investment in the future of Europe, and it should guide strategic thinking in Europe over the coming years. ***

Erik Berglöf When the transition process started in Central and Eastern Europe there was a sense of joining the West, with East Germany joining West Germany and Eastern Europe wanting to join Western Europe, or simply to be part of a United Europe. The prospect of this has been at the top of the political

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agenda in most if not all of these countries since then. They are expected to benefit strongly from membership of the EU, and public opinion has been firmly behind EU accession in most countries, or at least until recently. It is hard to overestimate the power of prospective EU membership in breaking domestic political deadlocks over difficult reforms and removing political constraints imposed by local interest groups. It has given the EU, whether it likes it or not, a role as an outside anchor to the reforms in Central and Eastern Europe. These countries’ reforms have been strongly affected by EU decisions on how the accession process is managed, the criteria used to evaluate applicants, the bargaining strategy, the time schedules established and the EU’s own internal reforms. The impact of this has been much stronger, much broader and more profound than any conditionality imposed by the IMF or the WTO. However, because of the weakness of enforcement inside the EU many essential reforms may be harder to implement once the countries in question have acceded. Events in Greece after its accession show the limitations of the enforcement powers of the EU. Therefore at the moment the EU has much stronger leverage over the reform process than it will when new members have joined, and it is probably much better at enforcing specific regulations than the newly established institutions are at implementing or interpreting them. For the latter, the outside anchor provided by the EU prior to accession is likely to be very important. EU’s role as an outside anchor has a number of implications for candidate countries that are not included in the next wave of accessions and whose reform achievements are not firmly secured and whose basic institutions are not deeply rooted. First, for these countries a prize, EU membership, is being held out as an incentive to break domestic political constraints. For this incentive to be effective, possession of the prize must not lie too far in the future as politicians and voters will not attach much weight to something that is unlikely to materialize for many years. Postponing entry beyond, say, 2005 could seriously weaken any leverage the EU has over candidate countries that find themselves at the bottom of the accession list. For this reason the timetable for important decisions on accession must be fixed. Second, membership should not be automatic or predetermined. By initially dividing the candidates into two tiers and including Estonia and Slovenia in the first tier the Commission managed to send a subtle but clear message: accession is determined by the extent of reforms, not by geopolitical considerations. Therefore it would still be worthwhile for, for example, Latvia and Romania to continue their reform efforts. Frequent and transparent checkpoints, as agreed upon in Luxembourg, were essential to keeping the process alive. The signals given to Latvia that they could join the first group were very important in this sense. Latvia has, in the face of very difficult domestic political and economic problems, shown a commitment

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to reform that should be rewarded. The prospect of joining the first group has sustained its reform efforts. Third, delaying membership can be a motivating force. Here again, Latvia is a good example. There was widespread disappointment when Latvia was not included in the first wave, but policy makers reacted by making an even greater effort. The compromises reached in Luxembourg were very important in sustaining the momentum of the reform, and without regular evaluations and the prospect of being ‘upgraded’ Latvia probably would not have come as far as it has. Fourth, the greater the opacity and vagueness of the criteria used to evaluate the candidates, the weaker the EU’s leverage and the more difficult the task of local reformers to sustain public support for accession. The Copenhagen criteria are intentionally vague, or at least in the case of the first two economic criteria, which concern competitiveness and the market economy. There should have been a deeper analytical foundation for these criteria, and a convincing rendering of the economic analysis underlying the competitiveness criterion has yet to be heard. Moreover it is hard to distinguish between the two criteria. The Copenhagen Declaration is not very informative, and the Agenda 2000 document only indirectly attempts to define the concepts. If the criteria are made more transparent to the applicants the EU’s leverage will be strengthened. So far we have assumed that the EU is acting in the interest of the accession countries, but much of the negotiation process suggests that this is not always the case. A more cynical view is that despite the fact that the present members will benefit from these countries’ reforms they are trying to extract extra benefits, and even transfers, from them in the bargaining process, ‘holding them down to their reservation utilities’ as we say in economics. Ironically, and perhaps intentionally, the criteria of accession are only clear when it comes to the acquis communautaire, the reforms that are most beneficial to the present EU members and often of dubious value to the accession countries. It might be helpful to puncture the image of the EU as a benign benefactor. Fifth, the EU’s role as an outside anchor gives it another reason to speed up its own internal reform as long as enlargement is being linked to these internal reforms, uncertainty about internal reforms will lower leverage. We have talked about the leverage exerted by the EU on the reform process in the transition countries. But as many have argued, in order to handle all the new members the EU must put its own house in order and speed up its internal reforms. Here the bait is the clout that a union of 25 would carry internationally, and the boost a successful eastward enlargement would give to the European project in general. The final implication concerns the role of the EU as an outside anchor in countries that have little or no chance of becoming members. Russia has

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neither been invited nor wants to join the EU, and it could be argued that this has contributed to the lack of direction of its reforms, which in turn made it vulnerable to the effects of the Asian crisis. The EU has a responsibility to engage with Russia as it shares a border with that country and several other former Soviet republics. Finland knows what it means to live next door to the Russian giant, as do many of the candidate countries, and it will be in the EU’s interest to offer Russia at least a minimal outside anchor. ***

Michael Landesmann If there is a theme that is a particular focus of this volume and pervades many of the contributions, it is the growing disparities that have characterized developments in Central and Eastern Europe and how the EU enlargement process has and will continue to affect these disparities. Those of us who have monitored developments in Central and Eastern Europe since 1989 know that the transformational recessions in some countries were deeper and more prolonged than in others, that some countries experienced almost no positive growth, and that economic recoveries were usually followed by severe relapses. Some of the contributors to this volume have expressed deep unease about the insights that economic analysis has been able to provide – especially ex ante – on the problems and complications that could (and did) arise in the course of the transformation. It is now apparent that the emergence of disparities was not restricted to the initial phase of transition: only a small number of transition economies have managed to lay the foundations for and embark upon a process of sustained growth, and even they have not been immune from temporary setbacks in the form of balance-of-payments crises, fragile exchange rate regimes and problems with their financial systems. Most of the countries that are not in the group of first-wave accession candidates have experienced a vicious circle of economic stagnation that has fostered political instability, and vice versa. These countries found it difficult to attract significant flows of foreign direct investment in the past, and the higher risk premia attached to them in the wake of the Russian financial crisis has meant a further drying up of international investment, a slowing down of privatization and a further falling behind in terms of industrial modernization and up-grading of their trade relations with Western Europe. An important theme in the conference that gave rise to this volume was the position of the second- and third-tier Central and Eastern European countries. We examined how the EU enlargement process was affecting their development and, with all the hype surrounding the EU accession negotiations with the first-tier accession countries, we discussed policies that could prevent a worsening of the disparities in Central and Eastern Europe.

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With regard to the first-tier accession countries, two particular issues were discussed: avoidance of the ‘Greece syndrome’, and the effect of EMU on the exchange rate policies these countries could or should pursue on the paths to accession and then full membership of EMU. In the case of the ‘Greece syndrome’ a session was tabled to discuss the experiences of previous accession countries, particularly those of the ‘cohesion countries’. As is well known, when these countries joined the EU their per capita income levels were well below the EU average (Ireland and the countries of Southern Europe) but improved thereafter. Despite labour market problems the progress of three of the four countries was remarkable. However, the experiences of Greece (and at the subnational level this is also true of many regions in the EU) have shown that structural problems can persist and that transfers from the EU Structural Funds merely provide a buffer against ineffective national polices. There is a danger that the ‘Greece syndrome’ will reappear in some of the accession countries or regions, so it is essential to formulate measures to avoid this possibility. With regard to the effect of EMU on the exchange rate policies of the accession countries, during the preaccession period and in the run-up to full EMU membership their exchange rate regimes could resemble those of the weak EU members (Spain, Italy and the UK) during the last phase of ERM1 in terms of sensitivity and vulnerability. This vulnerability will be compounded by the fragility of their financial systems, which are likely to be more detrimentally affected by exchange rate crises than was the case with the ERM1 countries. There is no doubt that during the pre-EMU phase policy makers will be faced by a dilemma. On the one hand, because the accession countries are still in the throes of dramatic structural change (in industrial composition, employment and wage structures, relative prices and so on) they will need more leeway in respect of exchange rate adjustments than do the more mature, structurally settled economies (which also happen to be their main trading partners). On the other hand the international capital markets will be highly sensitivite to any deviation from the strict path towards policy convergence, as measured by the degree to which exchange rate stability is achieved. Too much exchange rate rigidity or too much volatility could lead to an exchange rate crisis and capital flight, so a very fine line has to be drawn. It is to be hoped that the EU policy-making bodies will propose and support suitable exchange rate policies in this regard. One proposal that is currently being discussed is that the EU should set up a stabilization fund (possibly administered by the ECB in cooperation with the CEE central banks) to support a functional exchange rate regime for countries that are pursuing policies that accord with development targets associated with successful convergence. ***

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André Sapir What is the definition of Europe? How can we avoid, as Dariusz Rosati discussed in Chapter 11, a new divide in Europe? The EU we have now is a very different entity from that in 1985–92, which in effect was a customs union with a number of important common policies. On 1 January 1993 there was an important jump to the single market envisaged by the founding fathers, and from 1 January 1999 there was partial monetary union, with 11 of the 15 countries participating in EMU from the start. For want of a better definition we shall define Europe as consisting of the set of member states in the Council of Europe. At the moment there are 40 members, of which 15 belong to the EU and 12 have applied to join. The 40 countries that constitute the Council of Europe are so diverse that it is questionable whether the one- and two-speed models that are presently in use are suitable. Indeed without adaptation they could bring about the new divide feared by Dariusz Rosati. Therefore the question is, can an EU architecture be designed to deal with this diversity and reconcile the differing objectives of the member countries of the expanded EU. One area in which there is already a pan-European architecture – albeit a very unsatisfactory one – is trade. At the moment there are 93 regional trade arrangements, consisting of free trade areas or customs unions and involving 38 of the 40 European countries. Moreover 89 of these arrangements (mostly free trade areas) are bilateral and many involve the countries of Central and Eastern Europe. Russia, Ukraine, Moldova and Albania are the only five countries in the region that do not have free trade areas or customs unions with EU countries. All the others are connected to the EU via a complicated hub-and-spoke network. This problem requires a multilateral solution, perhaps along the lines of the GATT most favoured nation (MFN) clause. With, the present system, because of the diversity of the arrangements there is considerable discrimination. The introduction of a regional MFN clause would mean that whenever a country signed a regional trade arrangement with another it would have to apply the same rules to all the other countries of Europe. To be realistic, this would have to be limited to countries with which the EU already has regional trade arrangements, so the four countries mentioned above plus Belorus would, for the moment, be excluded. This would create a Pan European Free Trade Area (PEFTA). A subset of those countries that is the EU countries and the applicants but also some other countries would form the first step of my three-step architecture, and that step is the customs union – a customs union of a sort that we had before 1993 that is a customs union with a number of common policies. The second step would indeed be the single market, while the third step would be the monetary union. I believe that the main advantage of an architecture of this sort is that indeed it would provide a solution to the political problem – if not to

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all the economic problems – facing Europe today, which is to avoid a new divide. ***

Ferdinand Lacina I wish to make four points about the enlargement of the European Union. First, the EU has been heavily criticized for creating a split between the candidates for accession and those left out of the process. While one can agree with this criticism, the decision was not easy for the countries involved, nor for the Commission, which had to make certain choices. What is really important is to keep the process as open as possible, and to attend not only to the preparations for the accession of the candidate countries but also to the needs of the left-outs by providing substantial support for their economic development. Second, for some EU countries, and especially Austria, the positive effects of the enlargement have already been felt. For other countries there have been marginal effects in the form of free trade agreements. If one were cynical one could say that we do not feel a very high urgency and, given the situation in Austria and Germany but also in the southern part of the EU, this could be one of the weaknesses of the accession process. This is not an invitation for the Central and Eastern European countries to revise the free trade agreements. Rather it is a challenge to politicians not to confine themselves to economic consequences and to talk about the costs of nonaccession. It has been said that people are comfortable with the idea of enlarging of the EU, but it is not obvious that the people of Austria, for instance, or Germany or other EU countries, are really enthusiastic about a panEuropean entity. They merely accept it. Over a long period of time a lot has been invested in getting people to accept monetary and economic union, but expansion is not only an economic question, it is also a question of European security, culture, political development and preventing a new split between the countries of the continent. Third, as Erkki Liikanen correctly said earlier in this discussion, the EU has to do its homework, especially in respect of the reform of the Common Agricultural Policy (CAP) and the Structural Funds. Even without enlargement this would have been necessary. For instance, Commissioner Fischler has pointed out that without profound changes to the CAP there will be a return of large agricultural surpluses. Moreover it is not the admission of new member countries that is putting pressure on the CAP but the new round of world trade negotiations. It is of utmost importance that these issues be clarified in the public mind because otherwise EU farmers might get the impression that the CAP reforms are only due to the admission of new members.

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Finally there is the important question of the effects on the labour market. It is clear that there will be winners and losers. We have had already a lot of winners, but the general perception is not that we have gained jobs in Austria or in Germany or in other member countries of the EU – quite the contrary. Thus it will not be easy to convince trade unions and workers that there will be only a marginal effect on the labour market. To ensure the future of the European project in general we have to find ways and means to reduce unemployment substantially through a new dynamism, a new climate of growth and the creation of new jobs. This is perhaps the most important precondition for the success of eastward enlargement. Moreover, the credibility of the entire process of European integration will be at stake if we do not come to grips with the question of unemployment. ***

Jim Rollo In April 1994, Richard Baldwin suggested that the Central and Eastern European countries were too poor and too agricultural to be full members of the EU in less than two decades (Baldwin, 1994, Chapter 9). The point of this comment was that if money is the lifeblood of the Union then eastern enlargement was unaffordable in the short term unless the Central Europeans received second-class treatment. As was seen at the Copenhagen Summit in December 2002 (European Council, 2002), which settled the next enlargement of the EU; when finally the Council got to the money they engaged in real negotiations which, on agriculture and the Structural Funds, gave the new members less good treatment than incumbents. Thus Baldwin proved remarkably prescient: the central Europeans and Baltic states did enter ten years sooner than he predicted but on less than equal terms and will not reach equality on agriculture until 2013, precisely when he predicted (given the book was effectively written in 1993). How the negotiated outcomes on agriculture, the Structural Funds and the EU Budget will affect the future political economy of the Union is one of the major challenges from the 2004 enlargement. These issues will be addressed in the following short comments. The CAP dimension The Copenhagen summit left the new member states with no more than 25 per cent of direct payments to farmers (those payments now to be decoupled from production) commonly financed by the EU budget when they join in 2004. That will rise to 100 per cent by 2013 (the end of the next budgetary period). This is yet another part of a process of fixing the post2006 financial framework along an important dimension before the new members join the EU. And the budgetary pressures of enlargement on new members are quite significant (Spokeviciute, 2003; Mayhew, 2003). If, as negotiated, they top

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up these direct payments from their own budget, it is a serious budgetary problem. There already exist budgetary constraints in almost all new members. Add to that the fact that the costs of just adopting the acquis communautaire will require another 5–9 per cent on existing expenditure. Under these pressures they will find it hard to meet the excessive deficits procedures of the EU, let alone meet the Maastricht criteria for membership of EMU or the Stability and Growth Pact – all of which could put their future accession to EMU in danger. The new member states have bigger, some substantially bigger, agricultural populations, many on small, quasi-subsistence holdings, and have poorer rural infrastructure than the EU-15. The increased spending under the new second pillar of the CAP may help them. On the other hand, with so many very small holdings and weak administrative capacity they may find it hard to take advantage of the rural development funds or to meet the cross-compliance standards necessary to qualify for direct payments. If that turns out to be true, the combination of, at best, less than 100 per cent receipt of direct payments until 2013, and the possibility that many of their producers might in any case fail the cross-compliance test and receive nothing, may make them resistant to any reduction in border protection as main source of support to their farmers. They may increase the protectionist voice in the Agriculture Council after May 2004 when they formally join and make a successful completion of the Doha Round by the end of 2004 more difficult. More generally they are likely as a group to look to re-open the Copenhagen deal on direct payments (they have a blocking majority if they hang together (see Annex) which may be directly applicable in the Agriculture Council where Qualified Majority Voting, QMV, is the norm). They may also look for more direct budget support for rural infrastructure after 2006, particularly if they make no progress on direct payments, not least because they are exempt from modulation until 2013. Either of these approaches will throw them into direct conflict with the agreed limits on the agricultural budget. It is the EU-15 who will mainly lose receipts from the direct payments if the budget ceiling is breached under the financial discipline mechanism agreed in Luxembourg since any overspend is corrected by a reduction in direct payments in the case. Structural funds The term ‘structural funds’ is normally taken to mean the Regional and Social Funds but here will include the Cohesion Funds. This section will discuss them as a whole even though there are important differences in their operation. There are two problems facing the Funds. First, the net contributors to the structural funds may start to lose interest and the willingness to pay. There is a discussion going on about whether net contributors should only put in their net contributions and receive no receipts from the Regional Funds. The British finance minister, for example,

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has proposed repatriating regional policy spending in Britain and only paying the net contribution to Brussels. That is, Regional Fund payments to British regions would come from London not Brussels. Such an approach would undercut any political support for the regional policy in Great Britain among regional or local politicians. (The Sapir Group in its report to the President of the European Commission, in a similar vein, has proposed concentrating funds on the new members and the cohesion states in the long run (Sapir, 2003) with a focus on increasing growth. They suggest around 0.35 per cent of GDP for this function, which is less than the upper limit of 0.46 per cent on the structural funds but close to actual expenditure. Such approaches while arguably more economically efficient are likely to erode political support in the net payers for such policies.) Second, the current recipients want to maintain their position (eastern Länder, Spain, Greece, Portugal, Mezzogiorno). Even rich Ireland, whose GDP per head is now around 120 per cent of the EU-15 average (EU Commission, 2003, table 1) compared with the Regional Fund cut-off of 75 per cent and who might be thought of as potentially a large relative net contributor, wants to keep the money. Ireland, was a single region for the purposes of the regional policy until the last revision of regional boundaries. Then magically it became two regions. One, including Dublin and with a GDP per head well over 100 per cent of EU25 GDP per head and the other close to the limit of 75 per cent of EU GDP (EU Commission, 2003, map 1). This is one illustration of the political economy of the Structural Funds at work. The new members were offered full access to the structural funds at Copenhagen but with a cap on their receipts of 4 per cent of GDP as proposed in Agenda 2000. They may have difficulty reaching this cap soon (or at all) because of complex rules for planning and implementing projects, lack of administrative capacity to absorb and fully exploit these funds or lack of matching funds which amount to between one-third and 45 per cent of the total cost. So once members they may look for simpler disbursement rules and lower rates for co-financing. If they don’t make the 4 per cent cap, financing the structural funds budget might be relatively straightforward. But if they reach it early and consistently then the impact on structural funds spending could be over €25bn by 2013. On questions of political economy, first there is an upper limit on spending of 0.46 per cent GDP (European Commission, 1998b, section B; Inter-institutional agreement between the Council, the Commission and the European Parliament, 1999). Second unanimity is required for approval of structural funds budgets and is likely to remain so at least until after 2013 even if the proposed EU constitution is adopted as drafted by the Convention on the Future of Europe. Thus everyone has a veto. The net contributors, the current recipients and the new members will have to find a consensus, which creates a very difficult political economy.

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The budget The enlargement package agreed at Copenhagen is mean and that may poison the new members’ attitude in future negotiations. It is not just less than in Agenda 2000 (agreed by the Commission in 1998; European Commission, 1998a) it is even less than was agreed in March 1999 at the Berlin Council, where they cut back the Agenda 2000 proposals. The Berlin 2000–6 budget was designed for six new members joining the EU in 2002, not ten joining in mid-2004. This saved considerable funds since the four extra countries were small while the time period of membership was reduced by more than half from four years to 18 months. Thus the net contributors sewed up the Budget until 2006 first in Berlin in 1999 and again in Brussels in 2003. The total budget is barely more than 1 per cent of GDP. In real terms it has fallen back from the levels proposed in Agenda 2000 and in Berlin. Against that background the financial framework post 2006 is the real battlefield post enlargement. This is also a battleground where unanimity is required so everyone is condemned to reach a consensus. First, some context: the upper limit on the budget is set by the so-called ‘Own Resources’ (or budget income) ceiling, which is set at 1.24 per cent of Gross National Income (GNI). The Own Resources ceiling is not on the table since current expenditure is nowhere near the limit and the net payers have a veto. The EU budget is not allowed to borrow, so if its income is limited so is expenditure. And the EU15 have already limited the room for manoeuvre of the Commission and the net recipients. As noted above, the agriculture budget is frozen by the financial discipline mechanism agreed at Luxembourg in June 2003. Second, as also noted above, the structural funds are limited at 0.46 per cent of EU GDP and have been at this level since the 1993–99 Financial Framework and this could only be changed by agreement among the Commission, the Council and the European Parliament. And the actual level and distribution of the structural funds budget is also a matter of unanimity. So change there is going to be hard to make. Other constraints will also affect the negotiation. Romania and Bulgaria have been given very strong commitments on EU membership by 2007 in the Thessalonica European Council Conclusions of 20 June 2003 (European Council, 2003). Turkey was given the target of opening negotiations at the end of 2004 in the Copenhagen Council conclusions. Croatia has just applied for the candidature and Macedonia is on the verge of applying. So we have another five countries, and Turkey above all, which want to join the European Union and which could do so during the period 2007–13. Money for them will need to be part of the budgetary planning procedure. Turkey in particular is likely to weigh heavily on the minds of finance ministers because of its size (total population at 70 million, only 10 million less than the ten new members and much poorer and much more agricultural than the new members).

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Other policies are on the increase and budgets are under pressure, most notably security both internal and external. The Justice and Home Affairs agenda is likely to be at least partially Communitized after the next Intergovernmental conference in 2004 which could lead to some common financing particularly guarding external borders. The costs of stabilizing and preparing the Western Balkans for possible and eventual EU membership will along with programmes for the ‘near abroad’ of Ukraine, Belarus and Russia as well as North Africa and the Middle East all speak to a rapidly expanding foreign policy budget. Even if not part of the EU budget, increased defence cooperation could lead to downward forces on the EU budget envelope as national defence budgets come under pressure to increase. And the Lisbon agenda, which has the aim of making the EU the most technologically advanced, high productivity economy in the world by 2010 also demands increased expenditure on Union R&D budgets. So the increased demands on the budget come from elsewhere than just agriculture and the structural funds. Political economy of the budget after the enlargement of 2004 How is the political economy of this going to work out? It might be possible to carry out some complex game theoretic modelling but that is not the intention here. Instead three somewhat stereotyped and speculative scenarios are set out to give a sense of the possible forces at work based on weighting of votes in the Council set out in the Act of Accession (Act of Accession, 2003, Part 2, Title 1, Chapter 2, Article 11) which gives the maximum number of votes to constitute a blocking minority as 90 (see Annex). A new ‘Club Med’? All the net recipients gang together to expand the budget, in particular the so-called ‘Club Med’, which includes Italy, Spain, Greece and Portugal and Ireland (although Ireland starts phasing out of the Cohesion Fund from 2004 onwards), expands to include the new members. The aim would be to unfreeze the agricultural budget and perhaps to raise the share of the structural funds and in consequence raise the budget closer to the Own Resources ceiling. This might be done with the support of the Commission, which writes the initial Framework, and perhaps national members of the European Parliament who could threaten to block the Inter-institutional Agreement on the Framework. Each country has a veto, but more importantly as a group they do have a substantial blocking minority of 157 (186 votes if Italy joins in) out of 321. This might allow them to threaten the net payers on issues outside the Financial Framework which are important to the net payers as a group or individually and which are subject to Qualified Majority Voting (QMV). Equally, however, the net payers also constitute a, less robust, blocking minority of 99. The outcome will therefore depend on which group is most prone to defections (the recipients can afford many more defections than the net payers) as a result of side payments or threats

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and above all whether there are QMV issues on which the recipients can credibly threaten some or all of the net payers. ‘Club Med’ v. ‘new kids on the block’? This becomes a spoils fight between the new members and the existing cohesion states (the latter have a potential blocking minority of 99 but the cohesion states need Italy and France – defending its take from the CAP budget – to sustain the threat of a blocking minority) based on both marshalling a credible threat of a blocking minority that can be deployed elsewhere. This scenario is driven by an essentially frozen budget on agriculture and the upper limit on the structural funds plus the Germans and other net payers trying to drive in wedges to split the net recipients. The key targets of the new members are likely to be more money for direct payments and pillar two from the agricultural budget and easier disbursement rules for the structural funds. As we have seen in the past, the Spanish, in particular, are extremely adept at political infighting in the Council and have been very successful. They have also kept very close to Germany when they can and that long-term relationship could still serve them well in any budget negotiation. Both sides are very sensitive to defections and it may be hard to identify QMV decisions that damage one side only. New members v. candidates The new members, despite warm words now, may find it difficult to welcome the budgetary consequences of Bulgarian and Romanian accession in 2007 right at the beginning of the Framework period, let alone the possibility of Turkish accession during it. There are 10 million Bulgarians and 26 million Romanians, which is roughly equivalent to another Poland or half the size of the current enlargement (and 70 million Turks would be double that again). The impact on the distribution of receipts on agriculture and structural funds could be substantial, particularly if key elements of the Budget are frozen. This might encourage the new members to a strategy of delay on the next enlargement not least because pre-accession aid is outside agriculture and the Structural Funds budgets and thus outside any ceilings. Ties might lead to a policy of delay. Conclusions The political economy of the EU budget is likely to be messy after enlargement. It is too early to tell how it will work out but not too early to start thinking about the issue. In terms of the big choices confronting the EU: ●

●

Future agricultural reform is likely to be slowed by enlargement unless new members are given more cash after 2006. The Structural Funds seem unlikely to expand and if net payers lose interest and distance themselves from them politically then deals may be hard to strike in the next Financial Framework.

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●

The Financial Framework is an uncertain landscape, but the need for unanimity suggests stasis unless there are some levers external to the budgetary negotiations available to the demanders/net recipients. One of the most important issues to focus on may be whether there is any sign of blocking minority coalitions emerging among the new member states and/or among the net recipients as a group. Such coalitions have been hard to form and sustain in the past. Even if they do form, it may still be difficult to identify issues on which the coalitions can exert pressure on other players in the budgetary game. The next enlargement may also suffer. Bulgaria and Romania may join the European Union later than the promised 2007. And Turkey may be in the waiting room for a very long time .

Annex: blocking minorities in the enlarged EU Votes in the council The weighting of votes in the council Members of the council weighted votes Germany United Kingdom France Italy Spain Poland Netherlands Greece Czech Republic Belgium Hungary Portugal Sweden Austria Slovakia Denmark Finland Ireland Lithuania Latvia Slovenia Estonia Cyprus Luxembourg Malta (Total

29 29 29 29 27 27 13 12 12 12 12 12 10 10 7 7 7 7 7 4 4 4 4 4 3 321)

Political and Economic Challenges 395 Calculating a blocking minority The Act of Accession implies a maximum no of votes required for a blocking minority (i.e., assuming that those in favour constitute 62 per cent of the EU population) is 90 ((321 ⫺ 232) ⫹ 1) in a Union of 25. ●

●

●

The new members have a blocking minority of votes (99 votes) but could not survive the defection of any of Poland, Czech Republic or Hungary. The EU15 cohesion states (Spain, Portugal Greece and Ireland with 58 votes) would need support from Italy and France to sustain a separate blocking minority. The net contributors (Germany, Netherlands, Austria, Finland, Sweden and UK) also with 99 votes could only sustain defection by Finland.

Weighted voting after 2009 (for information) Articles 1–24 of the draft Constitution proposes that the weighting of votes set out above should hold until 1 November 2009. Thereafter a Qualified Majority would be constituted by member states representing at least 60 per cent of the population of the Union in areas where the constitution requires the Council to act on a proposal from the Commission (European Convention, 2003: 20). This proposal is controversial and for the moment there is no certainty that it will be adopted by the 2004 IGC or the European Council which is scheduled to consider the IGC’s conclusions in Spring 2004.

Note 1. The contributions in this chapter have been selected from the panel discussions held at the 25th Anniversary Conference of the Vienna Institute for International Economic Studies (11 to 13 November 1998; see the Preface for details of this event). The contributions reflect the views of the participants on the principal issues related to the unfolding process of EU Enlargement at that time. Jim Rollo’s contribution has been substantially revised from his original contribution to the panel discussion. It takes full account of developments up to summer 2003.

References Act of Accession, 2003: http://europa.eu.int/comm/enlargement/negotiations/treaty of accession 2003/pdf/3 act_of_accession/aa00003_re03_en03.pdf. Baldwin, Richard (1994) Towards an Integrated Europe (London: CEPR). European Commission (1998a) Agenda 2000: http://europa.eu.int/comm/agenda 2000/interim_en.htm#3. European Commission (1998b) Agenda 2000, section on Structural Funds: http:// europa.eu.int/scadplus/leg/en/lvb/l60013.htm. European Commission (2003) Second Progress Report on Economic and Social Cohesion: http://europa.eu.int/comm/regional_policy/sources/docoffic/official/reports/inte 2_en.htm. European Convention (2003) Draft Treaty Establishing a Constitution for Europe (CONV 850/03 EN): http://european-convention.eu.int/docs/Treaty/cv00850.en03.pdf. European Council (2002) Conclusions of the Copenhagen Council: http://ue.eu.int/en/ lnfo/eurocouncil/index.htm. European Council (2003) Conclusions of the Thessalonica Council: http://ue.eu.int/en/ lnfo/eurocouncil/index.htm.

396 Political and Economic Challenges Inter-institutional agreement between the Council, the Commission and the European Parliament (1999): http://europa.eu.int/scadplus/leg/en/lvb/l34003.htm. Mayhew, Alan (2003) The Financial and Budgetary Impact of Enlargement and Accession, SEI Working Paper No. 65, Sussex European Institute: http://www.sussex.ac.uk/ Units/SEI/pdfs/wp65.pdf. Sapir, Andre (2003) ‘An Agenda for a Growing Europe: Making the EU Economic System Deliver’: http://europa.eu.int/comm/commissioners/prodi/pdf/ agenda_for_growing_europe_en.pdf. Spokeviciute, Rasa (2003) The Impact of EU membership on the Lithuanian Budget, SEI Working Paper No. 63, Sussex European Institute: http://www.sussex.ac.uk/ Units/SEI/pdfs/wp63.pdf.

Name Index Acemoglu, D. et al. (2002) 12, 22 Johnson, S. 22 Robinson, J. 22 Adelman, I. 284, 310(n7) Al-Atrash, H. 349 Alesina, A. 30 Alesina, A. et al. (1996) 31, 47 Hausmann, R. 47 Stein, E. 47 American Bar Association (ABA) 142(n70) Anderson, K. 302 Andreff, W. 290 Artis, M. J. 212(n11) Asante, P. 360(n1) Auerbach, A. et al. (1999) 45, 47 Kotlikoff, L. 47 Leibfritz, W. 47 Azariadis, C. 168, 178, 180 Backé, P. 157 Bajec, J. 331 Baldwin, R. E. 190, 294, 302, 388 Baldwin, R. E. et al. (1997) 2, 22, 101(n10), 101, 188, 197, 202, 213, 243(n2), 244, 300, 311(n16), 312, 351, 354, 355, 359, 361 Francois, J. F. 22, 101, 213, 244, 312, 361 Portes, R. 22, 101, 213, 244, 312, 361 Barbosa, P. 263(n10) Barro, R. J. 244(n15), 291, 292, 311(n12) Bartolini, L. 211(n2) Basset, S. 360(n1) Bayoumi, T. 77(n6) Begg, D. 78(n13) Begg, D. et al. (2002) 171, 172, 182 Eichengreen, B. 182 Halpern, L. 182 von Hagen, J. 182 Wyplosz, C. 182 Beleza, M. 248, 249, 250, 252, 263(n7, n9–10) Berglöf, E. xiii, 13, 100(n1), 137(n1), 140(n51), 381–4 Berrigan, J. 348 Berthelot, Y. 310(n1)

Bhagwati, J. 81(n49), 90, 93, 97 Biesbrouck, W. 141(n61) Blejer, M. et al. (1997) 77(n4), 81 Frenkel, J. 81 Leiderman, L. 81 Razin, A. 81 Bliss, C. 38, 262(n3) Boeri, T. et al. (2002) 2, 5, 7, 8, 22 Bertola, G. 22 Brücker, H. 22 Corricelli, F. 22 de la Fuente, A. 22 Dolado, J. J. 22 Fitzgerald, J. 22 Garibaldi, P. 22 Hanson, G. 22 Jimeno-Serrano, J. F. 22 Portes, R. 22 Saint-Paul, G. 22 Spillimbergo, A. 22 Boldrin, M. 2, 180 Borjas, G. J. 198 Bork, R. H. 137(n12) Bourguignon, F. 262(n1) Braconier, H. 212(n3) Brada, J. C. et al. (1994) 137(n3), 143 Singh, I. 143 Török, Á. 143 Braga de Macedo, J. xiii, 13, 15, 28, 29, 38, 40f, 44, 45, 46f, 47n, 259, 262(n3), 263(n7), 310(n1) convergence programme (Q2) 249 ERM entry 249 Minister of Finance (Portugal, 1991–3) 249, 250, 252, 263(n7, n11) Braga de Macedo, J. et al. (1996) 262(n2), 264 Eichengreen, B. 264 Reis, J. 264 Braga de Macedo, J. et al. (2002) 262, 264 Nunes, L. C. 264 Pereira, L. B. 264 Branson, W. H. xiii, 13, 15, 16, 28, 29, 40f, 41, 44, 45, 46f, 47n Breuss, F. xiii, 2, 180, 181(n4), 187–8, 195, 202, 211(n1), 212(n9), 301, 308 Broeck, M. de 213(n13)

397

398 Name Index Brown, D. et al. (1997) 2, 22, 188, 201–2, 214, 301, 308, 312 Deardorff, A. 22, 214, 312 Djankov, S. 22, 214, 312 Stern, R. 22, 214, 312 Brücker, H. 197 Bufman, G. 80(n41), 82 Buiter, W. H. 19, 166 Cadilhe, M. 248, 251, 263(n9) Calmfors, L. et al. (1997) 15, 78(n6), 81 Flam, H. 22, 81 Gottfries, N. 22, 81 Matlary, J. H. 22, 81 Jerneck, M. 22, 81 Lindal, R. 22, 81 Nordh-Berntsson, Ch. 22, 81 Rabinowitz, E. 22, 81 Vredin, A. 22, 81 Calvo, G. 80(n30) Calvo, G. et al. (1996) 79(n24), 81 Sahay, R. 81 Vegh, C. 81 Campayne, J. 360(n1) Canova, F. 2, 180 Canzoneri, M. et al. (1996) 78(n6), 81 Valles, J. 81 Vinals, J. 81 Carré, H. 348 Catinat, M. et al. (1988) 195, 214 Donni, E. 214 Italianer, A. 214 Catroga, E. 250, 251, 263(n7, n9) Chinn, M. D. 79(n18) Christie, E. 340 Clark, P. 77(n1), 79(n23) Constancio, V. 263(n10) Coricelli, F. 172, 213(n13) Courchène, T. et al. (1993) 294, 312 Goodhart, C. 312 Majocchi, A. 312 Moesen, W. 312 Prud’homme, T. 312 Schneider, F. 312 Smith, S. 312 Spahn, B. 312 Walsh, C. 312 Covas, F. xiii, 259–60 Crespo-Cuaresma, J. et al. (2002) 175, 182 Dimitz, M. A. 182 Ritzberger-Grünwald, D. 182 Cross, R. 47n Csaba, L. 131, 141(n52), 141–2(n62–3)

Cukierman, A. et al. (2002) Miller, G.-P. 81 Neyapti, B. 81

54n, 81

Daianu, D. xiv, 375–9 Darvas, Z. 77(n1) de Haan, J. 213(n11–12) de Melo, M. et al. (1996) 284, 287, 312 Denizer, C. 312 Gelb, A. 312 Deardorff, A. 22, 214, 312 Denizer, C. 312 Deutsche Bundesbank 213(n13) Dimitz, M. A. 182 DIW 197, 212(n8) Dixit, A. K. 188, 195 Djankov, S. 22, 214, 312, 355, 361(n4) Dolgos, L. 142(n69) Domonkos, E. 142(n69) Donni, E. 214 Drazen, A. 30 Duso, T. et al. (2003) 138(n19), 143 Neven, D. 143 Roeller, L.-H. 143 Dutz, M. A. 138(n19) Easterly, W. 12 Efendic, A. 331 Eichengreen, B. 16, 19, 77(n6), 80(n42), 81(n49), 182, 264 Ekholm, K. 212(n3) Eliat, Y. 331 Ellison, D. L. 238, 244(n16) Emerson, M. 346, 358, 359, 361(n2) Enste, D. 331 Estrin, S. 356 European Bank for Reconstruction and Development (EBRD) 284 European Central Bank (ECB) 203 European Commission 2, 13, 77(n2), 137(n7–8) 150, 153, 159, 172, 175, 181(n1), 182(n7), 186, 188, 200, 202, 212(n4, n6) Fabiani, S. et al. (1997) 80(n36), 82 Locarno, A. 82 Oneto, G. P. 82 Sestito, P. 82 Faria, J. R. 213(n13) Fidrmuc, J. 15 Fidrmuc, J. et al. (2002) 181(n4), 183 Moser, G. 183 Pointner, W. 183 Ritzberger-Grünwald, D. 183

Name Index 399 Fidrmuc, J. et al. (2002) – continued Schmidt, P. 183 Schneider, M. 183 Schober-Rhomberg, A. 183 Weber, B. 183 Fingleton, J. 142(n64) Fingleton, J. et al. (1996) 118, 138(n22), 141(n57), 143 Fox, E. 143 Neven, D. 143 Seabright, P. 143 Fischer, S. et al. (1996) 80(n37), 82 Sahay, R. 82 Vegh, C. 82 Fischer, S. et al. (1998) 287, 290, 292, 313 Sahay, R. 313 Vegh, C. A. 313 Fischler, F., Commissioner 387 Flickenschild, H. 77(n1) Fox, E. 143 Franco, S. 251 Francois, J. F. 22, 101, 213, 244, 312, 361 Frankel, J. A. 41, 78(n12), 169, 203 Frenkel, J. 81 Fritsch, M. 142(n63) Froot, K. A. 356 Gabrisch, H. 243(n1, n7) Gács, J. 197 Gazzari, I. xviii Gelb, A. 312 Georgakopoulos, T. N. 226–7 Ghironi, F. 16, 19 Giorgianni, L. 80(n38), 82 Gligorov, V. xiv, 344(n3) Global Development Network (GDN) 175 Goodhart, C. 312 Grafe, C. 19, 166 Griffiths, M. 79(n22) Grob, S. xviii Gros, D. 203 Haber, G. 215 Hallerberg, M. 33 Hallett, M. 180 Halpern, L. 79(n19), 172, 182, 213(n13) Hamilton, J. 259, 260, 263(n14) Hansen, H. 142(n63) Harden, I. 31, 34 Hartig, P. 310(n1) Hausmann, R. 47 Havlik, P. 181(n4)

Havlik, P. et al. (2003) 326, 345 Landesmann, M. 345 Urban, W. 345 Wieser, R. 345 Havrylyshyn, O. xiv, 2–3, 6, 7, 287, 349, 355, 356, 361(n5) Helpman, E. et al. (1994) 80(n40), 82 Bufman, G. 82 Leiderman, L. 82 Hochreiter, E. 77(n1), 80(n35) Hoekman, B. 355, 361(n4) Hölscher, J. 142(n69) Holzner, M. xiv Hübner, D. xiv, 100(n1), 372–3 Hunya, G. 137(n1), 178, 181(n3) Inklaar, R. 213(n11–12) Inotai, A. xiv, 6, 13, 379–81 International Monetary Fund (IMF) 78(n10), 79(n23), 311(n10), 331 Italianer, A. 214 Jackson, M. 141(n61) Jaffee, D. M. 41 Jakab, Z. 78(n15) Jazbec, B. 172, 213(n13) Johnson, P. A. 284, 311(n7) Johnson, S. 22 Kaminsky, G. 79(n27) Karlsson, B. O. 163, 181(n6) Kawecka-Wyrzykowska, E. 18 Kern, M. 310(n1) Keuschnigg, C. 2 Keynes, J. M. 310(n2) Kohler, W. 2 Kopits, G. xiv–xv, 13, 15, 78(n17), 80(n28), 181(n4), 377 Korhonen, I. 15 Kornai, J. 311(n8) Kovács, C. 137(n7) Kovacs, M. 79(n19) Kowalewski, P. 243(n5) Kozul-Wright, R. 310(n6) Krajnyak, K. 79(n19) Kravtseniouk, T. 142(n69) Kröger, J. 213(n13) Krugman, P. 78(n12), 79(n20), 170 Lacina, F. xv, 8, 387–8 Landesmann, M. A. xv, 13, 137(n1), 178, 326, 344(n2), 345, 384–5 Laski, K. xv, xviii, 4, 5, 178, 182(n9) Laxton, D. 79(n23) Leiderman, L. 80(n41), 81, 82

400 Name Index Lejour, A. M. et al. (2001) 188, 202, 215 Mooij, R. A. de 215 Nahuls, R. 215 León-Ledesma, M. 213(n13) Lesguillons, H. 140(n48) Levcik, F. xviii Levine, R. 12, 291 Liikanen, E. xv, 12, 13, 370–2, 387 Lipschitz, L. 79(n28) Lloyd, P. J. 137(n2) Locarno, A. 82 Lolos, S. E. G. 156 Lopes, S. 263(n10) Lopez, J. 243(n1) MacArthur, A. 41 MacDonald, R. 78(n18), 79(n26) MacDonald, Ronald 47n Maddison, A. 237, 238t, 239f Majocchi, A. 312 Martin, P. 188 Masson, P. 79(n18), 80(n42) Matsushita, M. 139(n36) McDonald, D. 79(n28) McKibbin, W. J. 215 McKinnon, R. 80(n34, n44), 81(n48) Messerlin, P. A. xv, 100(n3), 137(n1) Micu, A. 142(n69) Mikek, P. 142(n69) Miklaszewska, E. 142(n69) Miller, G.-P. 81 Milosevi´c S. 304 Mlinaric, F. 142(n69) Mlynar, Z. 375 Modzelewska, E. 133 Moesen, W. 312 Mooij, R. A. de 215 Moreira, T. 248, 250, 251, 252, 263(n7) Morris, C. T. 284, 310(n7) Moser, G. 183 Moucque, D. 175 Mundell, R. A. 39 Murrell, P. 310(n6) Mussa, M. 81(n49) Nagy, M. 137(n5, n13), 139(n38), 141(n52) Nahuls, R. 215 Neck, R. 211(n2) Neck, R. et al. (1999) 188, 202, 215 Haber, G. 215 McKibbin, W. J. 215 Neven, D. 143 Neven, D. et al. (1993) 142(n72), 144 Nuttall, R. 144 Seabright, P. 144

Neyapti, B. 81 Nunes, L. C. xv, 264 Nuti, D. M. 141(n62) O’Hearn, D. 233 Oblath, G. 77(n1), 310(n1) Obstfeld, M. 78(n18), 79(n20) Oneto, G. P. 82 Organisation for Economic Co-operation and Development (OECD) 78(n13), 79(n22), 361(n6) Osiaty´nski, J. 137(n1) Panagariya, A. 90, 93, 101(n10) Pellegrin, J. 100(n8) Peneder, M. 326 Pereira, L. B. 264 Podkaminer, L. 243(n4) Pointner, W. 183 Popper, K. 377 Portes, R. 22, 101, 213, 244, 312, 361 Poterba, J. 32 Prud’homme, T. 312 Pujol, T. 79(n22) Rayment, P. B. W. 310(n1, n6) Razin, A. 81 Rebucci, A. 360(n1) Redonnet, D. 213(n13) Reinhart, C. 79(n27) Reis, J. 264 Reisen, H. 38 Reitschuler, G. 243(n5) Renelt, D. 291 Reuters 252 Richter, S. xv, 137(n1), 150, 181(n1) Ritzberger-Grünwald, D. 182, 183 Robinson, J. 22 Rocha de Sousa, M. 263(n7) Rodrik, D. 175, 243 Rodrik, D. et al. (2002) 12, 23 Subramanian, A. 23 Trebbi, F. 23 Roeller, L.-H. 143 Rogoff, K. 78(n18) Rollo, J. xvi, 388–96 Römisch, R. xvi, 4, 5, 178, 180, 182(n9) Romer, D. 292 Rosati, D. K. xvi, 11, 13, 18, 137(n1), 378, 386 Rose, A. K. 78(n12), 169, 203 Rosenthal, D. E. 139(n36) Rubin, P. H. 141(n62)

Name Index 401 Sachs, J. 77(n5), 355 Sahay, R. 81, 82, 313 Sala-i-Martin, X. 244(n15), 292 Sambuccini, G.-L. 310(n1) Sapir, A. xvi, 386–7 Sárai, J. 140(n41) Schäfer, G. 211(n2) Schengen 153, 186, 358, 359, 360, 381 Scherer, F. M. 137(n2), 139(n36) Schmidt, P. 183 Schneider, F. 312, 331 Schneider, M. 183 Schober-Rhomberg, A. 183 Schumpeter, J. A. 284 Seabright, P. 143 Servan-Schreiber, J. J. 375 Sestito, P. 82 Simon, A. 79(n19) Singh, I. 143 Slay, B. 118 Slebinger, M. K. 142(n69) Slok, T. 213(n13) Smith, S. 312 Somogyi, L. 142(n69) Sousa, A. de 250, 251, 263(n7) Spahn, B. 312 Stehrer, R. 178, 243(n12), 326 Stein, E. 47 Stephan, J. 142(n69) Stern, R. 22, 214, 312 Stiglitz, J. E. 188, 195 Strobl, E. xviii Subramanian, A. 23 Surányi, G. xvi, 12–13 Susmel, R. 259, 260, 263(n14) Svensson, L. 80(n41) Svetlicic, M. 310(n1) Symansky, S. 211(n2) Szapary, G. 78(n15) Székely, I. 181(n4) Tamirisa, N. T. 54n Temple, J. 284, 311(n7) Török, Á. xvi, 13, 141(n51), 142(n69, n72), 143 Hungarian competition policy (pre-1996) 137(n4) Tóth-Vizkelety, B. 142(n69) Trebbi, F. 23 Tsoukalis, L. xvi–xvii, 12, 373–5 Tudjman, F. 303 Tyers, R. 302

UNCTAD 142(n63), 178 UNDP 281n, 310(n4) Urban, W. 345 Vagliasindi, M. 138(n19) Valles, J. 81 Veblen, T. B. 284 Vegh, C. A. 81, 82, 313 Velasco, A. 30 Venables, A. J. 190 Vienna Institute for International Economic Studies (WIIW) 182(n8), 326 Vinals, J. 81 Vissi, F. 137(n9) von Hagen, J. xvii, 13, 15, 31, 32, 33, 34, 35t, 36, 47n, 182 Wakefield, S. 77(n1) Wallace, H. xvii, 371 asymmetry or reciprocity 369 eastward enlargement (propositions to encourage success) 365–7 hub-and-spoke or multilateralism 369 narrow or wide-angle lens 369–70 observations about previous experiences and current context 367–8 political and economic challenges facing ‘New Europe’ 365–70 shadows of past versus shadow of future 368–9 tipping balance in favour of successful enlargement 368–70 Walsh, C. 312 Weber, B. 183 Weise, C. 212(n8) Wieser, R. 345 Winckler, G. 80(n35) Winters, L. A. 2, 347, 349, 355 Wolf, T. 287 World Bank 119, 137(n6) Wyplosz, C. 79(n19), 168, 172, 182, 213(n13) Zettelmeyer, J. 79(n19) Zhang, W. 212(n11) Zinnes, C. 331 Zizmond, E. 142(n69)

Subject Index ABN-AMRO (Netherlands) 112 abuse of market dominance 119, 120, 121, 131, 137(n10) Competition Council’s caseload (Hungary, 1991–2002) 123f, 124, 125, 138(n27) accession countries 2, 47, 220, 228, 230, 240, 241t, 265, 383, 385, 395 catch-up timespan (v. EU-15) 241, 242t, 242 lessons from ‘cohesion countries’ 233–5 relevance of Greek experience 272 timetable for decisions ‘must be fixed’ 382 accession negotiations 47, 212(n6), 365, 367, 369, 373, 383 asymmetry 188 accession process 13, 203, 382 Accession Treaty (2002) 149, 186–7 Accounting Act (Hungary, 1991) 106 accounting rules/standards 105, 106, 109, 113 ACE-PHARE 142(n69) acquis communautaire (‘EU domestic laws’) 1, 13, 19, 49, 76, 87, 88, 158, 166, 171, 174, 186–8, 212(n4), 358, 365–7, 369–72, 383, 389 Act of Accession (2003) 392, 395 Act on Credit Institutions (Hungary) 115 administrative capacity 10, 389, 390 adult literacy 279, 280–1t ‘advantage of backwardness’ 178 advertising 129, 130, 140(n46–7) Agenda 2000 (European Commission, June 1997) 131, 141(n60), 187, 198, 199, 212(n9), 301, 371, 383, 391 Agricultural Bank (Hungary) 112 agricultural goods 349, 352 populations 389 products 89, 101(n11) reform 393 smallholdings 389 subsidies 11, 155, 157, 224t surpluses 387

agriculture 13, 22(n5), 52, 78(n10), 87, 92, 93, 95, 97, 99, 149, 150, 191, 191t, 192, 212(n6), 302, 311(n15), 323, 388 value added and labour force (1998) 53f see also CAP Agriculture Council 389 Agrobank (Hungary) 110 aid 309, 335, 336, 342 international assistance programmes 289 Albania 21, 268, 279, 286–8, 292, 304, 305, 311(n9), 312(n17), 315, 319, 331, 338, 340, 342, 344(n1, n4), 377, 386 balance of payments structure (percentage of GDP, 2001) 323t exports to EU (1997–2001) 329f, 330f, 330 external debt indicators (2001–3) 334t general government data (2001–3) 336t government spending on wages and salaries (2001–3) 337t informal economy 339 subsidies and transfers (2001–3) 338t see also CE-7 allocative inefficiency 106 Amsterdam 283 anti-competitive behaviour 120, 133 antidumping 87, 92, 94, 96, 99, 100(n7) antitrust measures 119, 131, 133, 141(n56) ARCH (autoregressive conditional heteroskedasticity) tests 259, 263(n12–13), 264(n14) Argentina 80(n32, n34) Armenia 349 Asian crisis (1997) 65–6, 73, 76, 80(n33), 376, 384 Asian tigers (Hong Kong, Singapore, South Korea, Taiwan) 63, 238t, 239, 240, 240f, 375 Association Agreements 265, 268, 303–4, 381 audiovisuals 89, 99

402

Subject Index 403 Austria 38, 87, 181(n7), 192–3, 195, 197–8, 203, 212(n4), 240, 387, 388, 395 biggest EU-15 winner from enlargement 200, 211 catching-up process 238t, 239 FDI flows (before and after accession) 300t, 300 hard currency strategy 73, 80(n35) integration effects (real GDP, 2001–10) of EU enlargement 201f macroeconomic effects of EU enlargement (2005–10) 208t migration from CE-8 region 8 Avis and Hertz 357 avisos 248–9, 252 Azerbaijan 356 bad debts/non-performing loans 63, 80(n31), 104–5, 107–8, 109, 110 balance of payments 320, 342, 384 see also trade balance Balassa–Samuelson (B–S) effect 17, 18, 18(box), 19, 170, 171–2, 176, 207, 213(n13), 290 Harrod–Balassa–Samuelson effect 57 Balkan countries/region 6, 7, 21–2, 101(n14), 176, 185, 187, 269, 304, 315–46, 376, 392 ‘integration preceding convergence’ (with EU) 344 PIN index (2000) 289t, 289 see also CE-7 countries; South-East Europe; SEE-4 Baltic countries 88, 89, 99, 161–2, 282, 284, 287, 301, 348, 357, 388 Baltic Free Trade Agreement 101(n11) Banco de Portugal 257, 262 Banco Totta 263(n9) Bank Austria Creditanstalt 243(n1) Bank of Italy 77(n1) banking 63, 73, 75, 80(n30), 223, 248, 254, 336, 340, 343 BIS accords 106 capital adequacy 103, 104, 106–7, 108, 109, 110 concentration 115 EU law 115 Hungary 12–13, 103–16 supervision 103–4, 113, 250, 252 Banking Act (Hungary, 1991) 106, 111 Banking Act (Hungary, 1993) 109 Banking Law (Portugal, 1992) 251 bankruptcy 106–7, 108, 110, 113

banks 126, 139(n33), 229 foreign 105, 113, 116, 166, 340 ownership structure 111 recapitalization 103, 107, 109–10, 112, 113 restructuring 165–6 small 115 Barcelona process 346, 354, 359, 361(n5) Barro growth equation 291 Bayerische Landesbank 111 Belarus 21, 287, 304, 306, 392 PIN index (2000) 289t, 289 see also CIS-4 Belgian franc 247 Belgium 99, 153, 181(n7), 195 Benelux 158, 187 BFGS (Broyden, Fletcher, Goldfarb, Shanno) algorithm 258 bipolar/multipolar world 376 blanket clause 121, 123, 125–6, 137 (n18), 138–9(n18, n30–6), 140(n40) application 126–7 Competition Council’s caseload (Hungary, 1991–2002) 123f, 125 bonds 108, 109, 110, 250, 311(n10) borders 192, 310, 392 ethnic, cultural (within individual states) 282 ethnic, national, cultural 277 Hungarian–Romanian 369 open 277, 288, 295 borrowing 271, 336, 338 Bosnia-Herzegovina 21, 282, 287, 303–5, 312(n17), 315, 331, 340–2, 344(n1, n4) balance of payments structure (percentage of GDP, 2001) 323t exports to EU (1997–2001) 329f, 330f external debt indicators (2001–3) 334t general government data (2001–3) 336–7t war (1992–5) 318 see also CE-7 boycotting/sanctions 138(n22), 340 Brazil 66 Bretton Woods 379 broad economic policy guidelines (BEPGs) 168–9 broad money (M2) 80(n30) Brussels (EU headquarters) 163, 241, 262(n3), 278t, 283, 283f, 285f, 286f, 310(n5), 377, 378, 379, 390, 391 Budapest Bank 110, 111–12 budget characterizations (von Hagen) 35t

404 Subject Index budget deficits 16, 17, 19–20, 28, 30, 33, 34, 38, 41, 43, 45, 50, 53, 58, 225, 267, 267f, 271, 290, 291t, 311(n10), 338, 389 direct financing prohibited 55 primary 40 reduction procedures 44 budget documents, informativeness 34, 35t, 36t, 37, 38 budget process bargaining approach 33 centralization index 36t, 38, 47 credible MAFAS 30–8 decentralization 31 distributional conflicts 30 four CE countries 34–8 international comparisons 38 political economy considerations 32–4 reform 47 role in economic transition 30–2 stages (four) 33–4, 35t, 36, 38 strategic dominance approach 33 budget surplus 39, 40f budgetary position, national 205 budgetary procedures 28 budgets 65, 79(n21) government 309 lost revenues 193 market-based hard constraints 50 national 156, 157, 158, 181(n4), 199 Bulgaria 88, 90, 101(n14), 159, 162n, 162, 174, 276, 287, 293, 301, 303, 305, 315, 319, 320, 326, 335, 342, 348, 391, 393, 394 banking and exchange rate crisis (1996) 318 integration effects (real GDP, 2001–10) of EU enlargement 201n Maastricht convergence criteria 210t real exchange rates (2000–2003) 173f see also CE-7, CEEC-7, CEEC-10, ‘Helsinki group’, SEE-4 Bundesbank 262(n5) business cycle 15, 19, 166, 168, 169, 170, 212–13(n11), 323 cross-country correlation 52 German, 213(n11) synchronization 203, 205, 211, 212–13(n11–12) US 212(n11) business ethics 122, 126, 129, 139(n32), 140(n44) business secrets, misuse of 138(n22)

CAP see Common Agricultural Policy capital 115, 195, 290, 349, 351 additional demand 197, 212(n2) destabilizing movements 170–1 diminishing returns 286 gross fixed 265, 266t, 266 marginal product 290 capital account liberalization 249 openness 55, 58, 59, 66, 76 safeguard clause 81(n51) short-term liberalization 75–6, 81(n50–1) capital cities 180 capital controls 66, 75, 80(n44), 81(n49), 248–9, 253 capital flow/movements 55, 59, 169, 231, 243, 298, 308, 359, 376, 379, 381 debt-creating 75 liberalization 254 capital goods 223 capital inflows 58, 74, 75, 177, 221–3, 232, 249, 262(n4), 270 controls 257 debt-creating 53 large 171 restrictions (Poland) 54 capital markets 30, 41, 166, 170, 181, 240 international 385 liberalized/liberalization 171, 228 transactions 178 capital mobility 29, 41, 49 capital outflows 65, 171, 174 capital flight 385 capital stock 166, 197, 351 capital transfers 211(n2) capitalism 275, 378 capitalist background 287 capitalist countries 220 entrepreneurial tradition 276 ‘captured states’ 341 carbon dioxide emissions 280–1t, 282 cars 97, 140(n46) cartels 119, 121, 123f, 124, 131, 138(n25) Casella effect 195 cash limits 34, 35t, 35 catching-up process 4, 167, 172, 177–8, 234–40, 284, 308–9, 315, 318 CEECs 289–94 cohesion countries 235 differential 178 Greece 266, 267f

Subject Index 405 catching-up process – continued projected timespan (accession countries v. EU-15) 241, 242t, 242 SEE 333–44 ‘unlikely to be accelerated by EU membership’ 242, 244(n16) see also convergence CE-7 countries (Albania, Bosnia, Bulgaria, Croatia, Macedonia, Romania, Yugoslavia) 286, 305, 307, 308 ‘civilization’ argument 307, 312(n17) distance from Brussels 278t, 283, 283f, 285f, 286f EU share of foreign trade (1997) 305, 306t, 306 government deficits (percentage of GDP, 2001) 291t growth performance (1992–2000) 287t HDI (UNDP, 1997) 281t inflation (2001) 291t ‘left-out’ countries 303 living standards 279, 280–1t, 282 per capita GDP (2000) 277, 278t, 283, 283f PIN index (2000) 289t population (2000) 278t CE-8 countries (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia) 7–8, 9, 21, 276, 286, 292, 298, 301, 308 distance from Brussels 278t, 283, 283f, 285f, 286f EU accession (2004) 294 EU share of foreign trade (1997) 305, 306t, 306–7 export structure 326 exports to EU (1997–2001) 329f, 330f, 330–1 government deficits (percentage of GDP, 2001) 291t growth performance (1992–2000) 287t HDI (UNDP, 1997) 280t inflation (2001) 291t living standards 279, 280–1t, 282 Maastricht criteria 290, 291t per capita GDP (2000) 277, 278t, 283, 283f PIN index (2000) 289t, 289 population (2000) 278t see also accession countries; CEE-4; CEEC-3; CEEC-5; CEEC-7

CEE-4 countries (Czech Republic, Slovakia, Hungary, Slovenia) competitiveness (indicators, 2001) 328f current account (percentage of GDP, 2002) 322f employment growth (1990–2001) 317f employment structure (2001) 325f exports (1990–2001) 319f FDI by sector (2001) 321t GDP structure (2001) 325f labour market indicators (2002) 318t labour productivity (1990–2001) 327f per capita FDI stock (1990–2001) 320f real GDP growth (1990–2001) 317f, 318 shadow economy (1999–2000) 332t trade balance (percentage of GDP, 2001) 322f unit labour costs (1990–2002) 328f wages (1990–2002) 327f CEE-8 countries (CEE-4 plus Poland and three Baltic states): same as CE-8 (qv) CEEC-3 countries (Czech Republic, Hungary, Poland) 189, 190, 191, 193, 197–8, 199, 200, 212(n2) dimensions of EU enlargement (1999) 191–2t FDI flows 196–7 GDP 191, 191t increase in GDP growth volatility due to EU enlargement (2001–10) 206f inflation volatility due to EU enlargement (2001–10) 205f see also EU-18 CEEC-5 countries (Czech Republic, Hungary, Poland, Slovakia, Slovenia) 202, 219, 240, 240t CEEC-7 countries (CEEC-5 plus Bulgaria, Romania) 202, 351 basic economic data and exports to EU (2001) 347t product composition of exports to EU (2000) 353t CEEC-8 countries (CEEC-5 plus Baltic countries) change in market share (industry categories, 1995–2001) 179f change in market share (skill categories, 1995–2001) 179f

406 Subject Index CEEC-10 countries (CEEC-7 plus Baltic countries) basic economic data and exports to EU (2001) 347t product composition of exports to EU (2000) 353t trade with EU (2001) 350t CEEC-10 countries (CE-8 plus Bulgaria and Romania) 189, 192, 197, 202, 293 benefits of EU accession 190, 192t, 194t, 198–200, 212(n5–9) change in market share (industry categories, 1995–2001) 179f change in market share (skill categories, 1995–2001) 179f dimensions of EU enlargement (1999) 191–2t GDP 191, 191t CEECs (Central and Eastern European Countries) 117, 118, 127, 186, 188, 189, 195–9, 202, 203, 205–7, 275, 302, 368–70, 384, 387, 388 consumer protection 139(n37) economic costs 90–3 economic effects of EU accession 149–84 exchange rate policy (EU accession context) 49–83 lower wages 197 trade policies 87–102 ‘unable to define preferred trade policy’ 88 CEECs: economic effects of EU accession 149–84 fiscal and financial aspects (issue of transfers) 149–63 growth implications of EU membership 174–81 macroeconomic implication of membership 163–74 net budgetary position (2003–6) 151–2t net-payer position 153 CEECs (CE-8 plus CE-7 plus CIS-4) absorption capacity 301 capitalist past 284 development gap 282–3, 308 differing economic performance (causes) 287–8 disparities in economic development 277–94, 310–11(n3–12) distance from Brussels 285f, 286f economic disparities (catching up) 289–94

economic disparities (dynamic perspective) 286–8 economic disparities (impact of EU enlargement) 294–307, 311–12(n13–17) economic disparities (implications for stability and security) 288–9 economic disparities (static perspective) 277–86 institutional reforms (2002) 285t less advanced 276–7, 286, 295, 308, 309 living standards 279, 280–1t, 282 membership index 285t, 285f more advanced 276–7, 284, 286, 295, 307 per capita GDP 277, 278t, 279, 283, 283f, 284, 310(n3) policy recommendations 307–10 PIN index (2000) 289t, 289 regional cooperation 310 two categories 276 uneven progress of transition 276 CEFTA see Central European Free Trade Agreement/Association CEI see Central European Initiative central banks 28, 30, 34, 45, 73–4, 77(n3), 80(n43), 103, 104, 105 CEE 385 independence 49, 54, 54t, 55 Portugal 247–55, 257, 260, 262(n4) statutes (Portugal) 250, 263(n9) Central and Eastern Europe (CEE) xviii, 49, 171, 212(n3), 367, 375, 380–1, 382, 384, 386 basic indicators (2002) 316t challenges 380 ‘conflict arena’ versus ‘bridge’ 296 impact of EU enlargement on economic disparities 275–314 Central Europe (CE) 27, 349, 351–60 definition 100(n2) exports 351, 352, 359 FDI 356 imports 354 market 348, 354 per capita GDP 349 Central Europe Towards Monetary Union (MacDonald and Cross, eds, 2000) 47n Central European Free Trade Agreement (CEFTA) 28, 47, 96–8, 101(n11–13), 134, 304, 310 Central European Initiative (CEI) 310, 310(n1), 373

Subject Index 407 Central European International Bank 112 central government 11, 13, 65n central planning 28, 30, 50, 53, 57, 79(n19), 172, 311(n8) cereals 227 CFA franc-zone member countries 78(n11) chemicals 233, 352 Chile 80(n34) CIS countries 14, 21–2, 296, 305, 307, 310 Asian republics 304 capital flows 2, 6 exports 349, 351, 352, 354, 359 factors favouring FDI 357 labour and human capital flows 2 side-effects of EU enlargement 2–3, 6, 7 trade flows 2 CIS countries: impact of EU enlargement 346–61 background and initial conditions 348–51 basic economic data and exports to EU (2001) 347t effects on foreign direct investment 355–7 labour and human capital flows 357–9 ‘must try harder at economic reform’ 357 product composition of exports to EU (2000) 353t trade effects 351–5 CIS-4 countries (Belarus, Moldova, Russia, Ukraine) 277, 304 distance from Brussels 278t, 283, 283f, 285f, 286f EU share of foreign trade (1997) 306t government deficits (percentage of GDP, 2001) 291t growth performance (1992–2000) 287t, 287 HDI (UNDP, 1997) 281t inflation (2001) 291t ‘left-out’ countries 303 living standards 279, 280–1t, 282 per capita GDP (2000) 277, 278t, 283, 283f PIN index (2000) 289t, 289 population (2000) 278t poverty 282 strategic orientation ‘uncertain’ 304 civil courts 130, 139(n33, n35), 140(n41)

civil society 378 civil turmoil 357 civil unrest 287, 304 civil war 318 ‘clash of civilizations’ 376 ‘cleft countries’ (Huntington) 304, 307, 312(n17) clothing 87, 92, 94, 95, 99 ‘Club Med’ 392–3 Cobb–Douglas technology equilibrium 190 cohesion countries (Greece, Ireland, Portugal, Spain) 3, 181, 199, 219, 220, 385, 390, 393, 395 convergence with EU average 235–43 exports as percentage of imports (1960–2000) 229f external position 219–35 FDI flows (1970–2000) 231, 231t GDP per capita (1960–2000) 236t, 244(n13) GDP per capita (Geary–Khamis dollars, 1950–2002) 238t, 239f, 240, 240f lessons for ‘accession countries’ 233–5 methodological remarks 235 non-commercial transfers from EU 230 reorientation of FDI flows to accession countries 212(n3, n9) Cohesion Fund 5, 10, 19, 153, 156–9, 162t, 162, 180, 224t, 225, 232, 389, 392 collusive horizontal arrangements 133 commercial banks 104, 106, 107 state-owned (Hungary) 105, 107–8, 113 Commercial and Credit Bank (Hungary) 112 Common Agricultural Policy (CAP) 3, 12, 21, 149, 154, 155, 163, 186, 187, 198, 199, 212(n7, n8), 301, 378, 380, 387, 388–9 budget 393 cross-compliance standards 389 McSharry reform (1995) 302 reform 370 second pillar 389, 393 Common Commercial Policy 187, 192 Common External Tariff 192 common pool problem 32, 33 communications 180, 282 communism 283, 284, 295 collapse/fall 269, 276, 375

408 Subject Index Community Support Frameworks 199 companies CEEC 94 Czech 100(n8) EU 94 export-intensive/import-intensive 223 foreign 178, 223, 233 insurance 114 mail-order 140(n46) major international 223 multinational/transnational 212(n3), 232–3, 298 pharmaceutical 130, 139(n33), 140(n49) comparative advantage 39, 89, 178, 341–2, 348, 349, 352, 355 competitive advantage 124, 140(n40) competition 108, 113, 131, 297, 375 distorted 154–5 EU rules 5 fair 211 global technological 379 unfair 121, 122, 130, 138(n22), 141(n56) Competition Act (Hungary, 1990) 118, 120, 121, 125, 130, 141(n52) amendments 141(n55) blanket clause 121, 123, 125–6, 137(n18), 138–9(n29–36), 140(n40) eight areas of competition law 121–2 Competition Act (Hungary, 1997) 118–19, 120, 121, 124, 127, 137–8(n18) blanket clause repealed 137(n18) Competition Acts (Czech Republic and Slovakia) 132 competition authorities 133, 134, 142(n72) competition law/legislation 118, 128, 130, 131, 132, 140(n41–4, n50) competition policy 141(n60, n62), 187, 241, 341 cost–benefit approach 131–2 effectiveness (Hungary) 131–4, 140–2(n51–72) EU 120, 137(n7), 170 European and Japanese (comparative assessment) 139(n36) first-generation 118 global 137(n2) Hungary 13 quantitative analysis 121

second-generation 118 transition-oriented 119–20, 137(n6–8) ‘competitive relationship’ 130–1 competitiveness 6, 56, 58, 65, 77, 79(n28), 230, 233, 234–5, 244(n16), 298, 326, 331, 341, 343, 344, 352, 353, 381 artificial 226 international 211 relative 195 competitors 126, 128, 138(n25), 351, 352 complexity 376 Computable General Equilibrium (CGE) models 193 concentration of ownership 125 ‘consolidation agreement’ (Hungary) 110 constraints hard-budget 72 soft budget 339 state power 118 consumer deception 121, 123, 127–31, 138(n24), 139(n33), 139–40(n37–50) Competition Council’s caseload (Hungary, 1991–2002) 123f, 125 ‘consumer fraud’ 128(n23) ‘consumer emancipation’ 125 consumer goods 220, 340 consumer price inflation 114, 205n consumer protection 132, 139(n37), 140(n42) consumer spending 230 consumers 93, 98, 126, 131, 226–7 consumption 58, 114, 339, 340, 344 contagion effects 59, 66, 75, 79(n27), 81(n50) ‘Continental model’ 375 Convention on the Future of Europe 390 convergence 11, 39, 46, 51, 57, 244(n16), 246, 267 budgetary (1992–2002) 207f developmental 170 GDP growth (1992–2002) 206f group procedure 47 income 10 income (or real) 290 lacking 293, 311(n12) limited 276 neoclassical hypothesis 290, 293, 311(n12) policy (or nominal) 290, 311(n11) price-level 170 regions 238 see also catching-up process

Subject Index 409 convergence programmes 49, 168–9 convergence, stability and growth programme (PCEC, Portugal) 251 Copenhagen Declaration 383 Copenhagen economic criterion 203 core investors, non-state 113 corporate borrowing, long-term 114 corporate governance 141(n51), 341, 377 corporate sector 114 corporation tax (Ireland) 232 Council of Baltic Sea States 310 Council of Europe 373, 386 Council for Mutual Economic Assistance (CMEA) 96, 105 courts of law 121, 130, 141(n52, n56) covariance stationarity 258, 263(n13) credibility 54, 56, 66, 73–4, 246, 247, 252, 253–4, 255 CEEC economic transition 95–6 MAFAS 30–8 credit creation 45 credit institutions 103, 116 credit ratings 168 credit rationing 47 credit requirements, new 230 credits 219 Croatia 303, 305, 311(n9), 315, 316, 318–20, 323, 326, 330, 331, 335, 340, 342, 344(n4), 391 currency tied to euro 306 real exchange rates (2000–2003) 173f see also CE-7, SEE-4 cross-border corporate activities 180 currency 5, 59, 235, 250, 262 depreciation 234 domestic 221 foreign (net outflows) 234 non-convertible 247 over-appreciated 323 stable and convertible 252 currency board arrangements 65, 66, 74, 80(n32), 174, 204, 207 currency convertibility 43, 246, 248, 252, 253, 257, 299 currency crises 53, 65–6, 73, 75, 76, 78(n13), 174 current account 223, 225, 226, 233, 335 balance 41, 199 convertibility 75 deficits 43, 44, 114, 156, 205–6, 227, 228, 242, 320, 333 external imbalances 55 financing 232 imbalance 53

liberalized 54 openness 250 positions 211 SEE 333 structural deficits 177 surplus 228 unsustainable positions 174 customers (Opel Hungary Ltd) 138–9(n31) customs unions 98, 101(n11–12), 187, 190, 192, 270, 297, 298, 346, 386 Cyprus 4, 149, 156, 159, 161, 162t, 185, 186, 210t see also accession countries; ‘Luxembourg group’ Czech Republic 2, 19, 27, 28, 30, 44, 47, 51, 55, 57, 60, 89, 90, 91f, 140(n43), 149, 153, 159, 162t, 162, 193, 196, 197, 199, 200, 202, 206, 284, 287, 290, 297, 395 bad debt problem 107 ‘benefits likely to outweigh costs’ (ERM-2 membership) 76 budget balance (1998–2002) 167f budget process 34–8 capital account openness 54 catch-up timespan 242 central government deficit (1993–2002) 37t central government spending (1993–2002) 37t competition authorities 132, 141(n58) crisis (1997) 63, 73, 80(n30, n46) currency crisis 53, 78(n13) customs union with Slovakia 101(n12) exchange rate and interest rates (1997–9) 68f exchange rate and monetary framework (2001) 54t exchange rate policy 50 exchange rate realignments 174 exchange rate and unit labour costs (1993–8) 62f external account and exchange rate crises (1997–8) 176 financial indicators (1993–9) 64t gains from EU enlargement 211 GDP (1995–2002) 177f GDP deflator (1996–2002) 164f impact of Asian crisis (1997) 66 integration effects of EU enlargement (real GDP, 2001–10) 201f integration effects of EU enlargement (real GDP, 2005–10) 194t

410 Subject Index Czech Republic – continued interest rates (1998–2002) 165f Maastricht convergence criteria 210t macroeconomic effects of EU enlargement (2005–10) 208–9t MFN and Europe Agreement tariffs (1991–2000) 91f path to ERM-2 72 per capita GDP (1989–2002) 240, 240t performance indicators (1993–9) 55t preferential average concessions (1991–2000) 94f, 100–1(n9) real exchange rates (2000–2003) 173f restructuring 80(n46) sterilized interventions 78(n15) trade with EU 2000 (percentage of GDP) 52f value added and labour force (1998) 53f see also CE-8, CEE-4, CEEC-3, CEEC-5, CEEC-7, CEEC-10, EU-18, ‘Luxembourg group’ Czechoslovakia 30, 37, 88, 89, 96, 202 damages 139(n33), 140(n41) data insufficiency 29, 44, 45, 80(n28), 124, 200, 223, 289, 331, 335, 339, 344(n1), 349, 357, 358, 359 debt 28 foreign 29, 44, 229, 253, 263(n11), 333–5 government 50, 290, 311(n10) national (Hungary) 110 public 18, 19–20, 42, 44, 45, 52, 267, 271, 336 public sector 76 short-term domestic 262(n4) debt servicing 29, 229, 249, 336, 336–7t debt sustainability 38, 42–3, 45, 333 debt-for-equity swaps 105 ‘deep’ integration 365, 366 ‘given precedence over widening’ 375 problem of reconciliation with accession of new members 373 defence 336, 338, 368, 392 Défi Américain/American Challenge (Servan-Schreiber) 375 demand 40, 138(n25), 178, 189, 196, 199, 222, 230, 326 domestic 234–5, 271 shocks 204 demand pressures 80(n46) democracy 188, 242, 263(n6), 288, 295–6, 303, 304, 377, 378

demography 166, 178, 338 Denmark 14, 38, 87, 182(n7), 200, 211, 249, 299t, 300, 311(n14) Deutsche Genossenschaftsbank 112 Deutschmark 54, 80(n39), 226, 228, 253, 263(n7) shadowed by escudo (1990–2) 247, 248, 249, 261t, 262(n5) devaluation 43, 44, 203, 253, 267 competitive 211 real 46f, 46 developing countries 6, 58, 99, 310(n7), 349, 351, 352 development traps 175, 332 direct payments 388–9, 393 Copenhagen deal 389 domestic investment 220, 243 domestic savings 220, 221, 222, 223, 230, 243(n3) domestic stability culture (Portugal) 250 downturns 78(n7), 168 drachma 249, 266, 267 dritter Weg (third way) 375 Drugs Act (Hungary) 130 Dublin 244(n11), 390 ‘Dutch disease’ 323 Dynamic Multiple Indicators Multiple Causes (DYMIMIC) 331 East Germany (GDR) 230, 381 Eastern Europe 189, 190, 202 integration effects of EU enlargement (real GDP, 2001–10) 201f integration effects of EU enlargement (real GDP, 2005–10) 194t per capita GNP 371 Soviet domination 276 EBRD see European Bank for Reconstruction and Development ECB see European Central Bank ECOFIN (Council for Economic and Financial Affairs) 203, 249, 251, 257 econometrics 78(n12), 121, 138(n19), 175, 203, 347 economic base 371 economic benefits 296–301, 312(n13–14) dynamic 296–7 static 296–7 economic depression 104 economic disparities/gap 374 impact of EU enlargement (CEE) 275–314

Subject Index 411 economic growth/GDP growth 11, 13, 19–20, 57, 202, 227, 234, 243, 244(n16), 266, 267, 271, 289, 290, 308, 311(n7, n11), 368, 369 acceleration 232 differentials 176 enhancement 171, 180 fast 18, 18(box), 19 observed differences between paths 292 obstacles 39 performance (EU-15, CEECs, 1992–2000) 286, 287t potential 195 SEE 332–44 statistical measures 182(n9) steady-state 229, 230, 243(n9), 293 sustainable 55, 181, 287, 344, 380 sustained 309, 315 theory 4, 202, 203, 286 economic growth rates 229, 240, 242t, 242, 243(n8), 289, 311(n9, n12), 335 EU-15 268f expected 166 Greece 268f real 237 volatility 168, 205, 206f economic orthodoxy ( pensée unique) 373 economic performance 300, 311(n13), 378 economic policy-making, advisory work 122, 138(n21) economic reform 357 economic stabilization 266 economic stagnation 384 economies of scale 92, 179, 195, 297 economies of scope 179 ECU 246, 248, 250, 255, 260, 262(n2, n5) Ecuador 66, 80(n45) education 6, 7, 156, 166, 279 school enrolment 279, 280–1t, 292 effective market classification (principle) 38, 40 efficiencies 137(n12), 188, 190, 351, 359 allocative and X-type 57 electricity use 280–1t, 282 empiricism 15, 31, 77(n4, n6), 79(n22–3), 175, 212(n9), 223, 292, 347

employers’ associations 250 employment 78(n10), 175, 176f, 191t, 193, 195, 212(n3), 221, 222, 227, 230, 247, 250, 297, 317f, 318, 338–9, 342, 368, 369, 385 job losses 5, 6 job security 381 SEE 338–9 public sector 267 employment exchanges 319 EMS see European Monetary System EMU see European Monetary Union energy 79(n22), 138(n31), 223, 340, 349, 356 English language 271 entrepreneurial fabric (tissu industriel) 134, 142(n67) ‘entrepreneurs’ 120 environment business 6, 12, 13, 140(n44) legal 28, 113–14 natural 156, 158, 166, 279, 282, 302, 368 political 287, 288 ERM see European Monetary System/Exchange Rate Mechanism Erste Bank (Austria) 112 escudo consequences of system instability 247 conversion rate 246, 249, 251, 255 crawling peg (1977–90) 247, 248, 257, 261t, 262 Deutschmark shadowing (1990–2) 247–9, 252–3, 257–62, 262(n5), 263–4(n12–14) domestic disturbance 247 ERM entry (1992) 247–50, 253, 255, 257 exchange rate regimes 248–52, 262–3(n2–9) ‘false stability’ 255, 257 moving into euro 246–64 origins 262(n2) realignments 254–5, 256t turning points 247 volatility 247, 254, 255, 257–62, 263–4(n12–14) Estonia 4, 19, 53, 54, 57, 65–6, 80(n39), 101(n11), 149, 174, 197, 292, 297, 382 ‘benefits likely to outweigh costs’ (ERM-2 membership) 76 budget balance (1998–2002) 167f customs law 89, 100(n5) effective rates of protection 78(n14)

412 Subject Index Estonia – continued exchange rate and interest rates (1997–9) 71f exchange rate and monetary framework (2001) 54t exchange rate policy 50, 66 exchange rate and unit labour costs (1993–8) 62f financial indicators (1993–9) 64t GDP (1995–2002) 177f GDP deflator (1996–2002) 164f import tariff rates 78(n14) interest rates (1998–2002) 165f Maastricht convergence criteria 210t path to ERM-2 72, 80(n39) performance indicators (1993–9) 55t trade with EU 2000 (percentage of GDP) 52f value added and labour force (1998) 53f see also CE-8, CEEC-10, ‘Luxembourg group’ ethnic animosities/conflicts 275, 287, 295, 305, 310, 340 EU-10 (EU-15 minus Luxembourg and cohesion countries) 238, 238t, 239f GDP per capita (Geary–Khamis dollars, 1950–2002) 238t, 240, 240f EU-11 (EU-15 minus cohesion countries) GDP per capita 235, 236t, 237t, 244(n13) ‘EU-13’ 194t EU-14 (EU-15 minus Luxembourg) 293 EU-15 see European Union EU-18 (EU-15 plus CEEC-3) increase in GDP growth volatility due to EU enlargement (2001–10) 206f inflation volatility due to EU enlargement (2001–10) 205f EU-25 88, 149, 158, 161, 162t, 162 agenda for future reform 20–2 Eastern [CIS] dimension 21–2 fiscal policies 19–20 macroeconomic diversity 20 per capita GDP (1995–2013) 160–1t trade policies 98–100, 101(n14) EU-27 159, 162t, 162 per capita GDP (1995–2013) 160t, 161t euro 54, 74, 76, 80(n39), 172, 204, 311(n11), 340, 343, 348, 375 CEEC exchange rate policies oriented towards 206–7 escudo moving into 246–64 single currency 43

use as domestic currency (SEE) 343 see also European Monetary Union ‘euro hold-up’ 247, 257 euro zone 27, 38, 51, 77(n2), 189, 190, 197 budgetary convergence (1992–2002) 207f business-cycle synchronization 205, 213(n12) current account divergence (1992–2002) 207f ‘fewer EU member-states in than out’ 211 GDP growth convergence (1992–2002) 206f inflation (2001) 291t inflation convergence in run-up to EMU (1992–2002) 204f interest rates (1998–2002) 165f euroization 80(n45) Euromoney 263(n11), 311(n13) Europe definition 372, 386 ‘far from being homogenous’ 275 growing disparities 273–361, 384 impact of EU enlargement on CEE 275–314 key to stability 289 new divisions 358, 378, 386–7 political situation 242 prospects for further (South-) Eastern EU enlargement 315–46 regional security and stability 307 Europe Agreement (Hungary, 1991) 118, 120(n8) changes in competition law induced by 120–1, 130, 134, 137(n9–15), 140(n48) harmonization objectives 137(n11) Europe Agreements 89–98, 100(n5–6), 187, 303, 305, 342 ‘asymmetry’ provision 92 costs and benefits 90 economic costs 92 ‘hub and spokes’ regime 90, 96, 369, 386 outward processing traffic (OPT) quotas 93–4, 100(n8) political benefits and costs 95–6, 98, 101(n10) safeguards (cases of ‘serious disturbance’) 94 tariffs 91f European Agricultural Fund for Guidance and Guarantee (FEOGA) 22(n5), 311(n15)

Subject Index 413 European Bank for Reconstruction and Development (EBRD) 29, 111, 112, 284 EBRD index of institutional reforms 284, 285t, 285t, 286f European Central Bank (ECB) 17, 174, 205, 311(n11), 374–5, 385 European Commission 77(n1), 168, 174, 248, 249, 262(n3, n5), 367, 370, 371, 382, 387, 390–2, 395 dual role 372 five options for free movement of workers 212(n4) Information Note (January 2002) 150 Second Cohesion Report (2001) 153 structure of merger decisions (1990–2002) 136t, 142(n68) ‘White Paper’ (1995) 120, 137(n7–8) European Council 19, 49, 88, 168–9, 393 blocking minorities in enlarged EU 394–5 weighted voting after 2009 395 weighting of votes 371, 394 European Council Directive 4064/1989 119 European Court of Justice 120 European Economic Community (EEC) 87, 187, 270 EC-6/EC-9 265 European Free Trade Association (EFTA) 98, 185, 187 European Fund for Regional Development 311(n15) European integration 163, 262(n3), 373, 388 à deux vitesses (flexible) 211 capital markets 170 deep integration 170 effects of EU enlargement 190–203, 211–12(n2–10) EU/EMU 170 ‘harms third parties, although net magnitude is very small’ 360 institutional and legal 180 labour markets 170 one- or two-step 203–11, 212–13(n11–13) product markets 170 SEE 332–44 twelve concentric circles (Emerson) 346, 361(n2) European Monetary System (EMS) 211, 212–13(n11), 246 Exchange Rate Mechanism (ERM) 22 (n3), 171, 225, 228, 249, 311(n10) ERM-1 385 Greek admission (1998) 267

ERM-2 14–15, 49, 50, 57, 59, 72–4, 76–7, 80(n34–45), 203–4, 211 band (of fluctuation) 267 convergence strategy 74 Greek admission 267 key conditions 49 three-phase approach before entry 73–4 general code of conduct 246, 247, 250–1, 252, 253, 257 crises (1992) 253, 376 crisis (Portugal) 252–5, 261t, 261, 262, 263(n10–11) entry 172 exchange rate criterion 15, 22(n4) Portuguese entry (1992) 247, 248, 249, 250, 253, 255, 257 widening of bands (1993) 247, 256t, 257, 261t, 261, 262 European Monetary Union (EMU) 1, 2, 3, 49, 73, 75, 76, 78(n6), 186–9, 192, 203, 205, 228, 247, 249, 251, 257, 260–2, 267, 368, 371–4, 380, 385, 386, 389 accession of new-member countries 13–20 accession rules 172 benefits 169 CFA franc-zone member countries 78(n11) entry 171, 172 inflation convergence (1992–2002) 204f Ireland 226 membership 163–4, 166, 168 optimum currency area 50, 77(n4) policy options 16–17 political consequences/considerations 16, 169 preliminary issues 14–15 stage three 49, 77(n2), 81(n47), 204, 205 timing 169, 170, 174 European Parliament 149, 391, 392 European Social Fund 22(n1), 311(n15) European Union (EU-15) 2, 3, 9, 14, 20, 87, 97, 99, 149, 153–4, 159, 162–3, 166, 174, 181(n1), 202, 205, 226–8, 234, 265–6, 267f, 353, 374, 381, 389, 391 à la carte organization 188 accession criteria 186–7, 188

414 Subject Index European Union (EU-15) – continued accession ‘superior vehicle for integration’ 346 anchor/beacon/demonstration hypothesis 288, 355, 356, 360, 382 area and population 185 basic economic data (2001) 347t basic principle 181(n5) change in market share (industry categories, 1995–2001) 179f change in market share (skill categories, 1995–2001) 179f costs of CEEC-10 accession 190, 192t, 194t, 198–200, 212(n5–9) costs of non-enlargement 376, 387 current account balance 199 current account divergence (1992–2002) 207f ‘customs union, not a free trade arrangement’ 297 dimensions of EU enlargement (1999) 191–2t directives 103 distance from Brussels 278t, 283, 283f, 310(n5) ‘don’t do what we did, do what we say’ 243 Eastern enlargement (2004) 185, 203, 294 economic growth rate (projected) 242 flexible integration 189 four sets of challenges (Inotai) 379–81 fourth enlargement (1995) 185, 203 ‘future-oriented dimension’ needed 369, 371 GDP (1995–2002) 177f GDP per capita 186, 191t GDP deflator (1996–2002) 164f GDP growth convergence (1992–2002) 206f generational change 380 Greek presidency (2003) 186 growth performance (1992–2000) 287t HDI (UNDP, 1997) 280t heterogeneity 186, 371 imports 349, 351, 354 increase in GDP growth volatility due to EU enlargement (2001–10) 206f inefficient producers 93

inflation convergence in run-up to EMU (1992–2002) 204f inflation volatility due to EU enlargement (2001–10) 205f integration effects (real GDP, 2001–10) of EU enlargement 201f internal challenges 379–80 intra-EU trade goods (1981–2000) 269f large countries 195, 197 ‘left-out’ countries 294 loan 46f, 46 main investor in SEE 342 merger law 120–1, 137(n12) MFN and Europe Agreement tariffs (1991–2000) 91f ‘more than customs/currency union’ 170 new members v. candidates 393 non-core members 51, 52 northern enlargement (1973) 185 objective 1 status 185 obligations/prerequisites of membership 49–50, 77(n2) partnership and cooperation agreements 346 per capita GDP (1989–2002) 240, 240t per capita GDP (1995–2013) 160t per capita GDP (2000) 277, 278t, 279, 283, 283f, 310(n3) political role (SEE) 342 population (2000) 278t preaccession strategy 187 preferential average concessions (1991–2000) 94f, 100–1(n9) prosperous non-member countries 244(n16) quality of leadership 373 quasimembership (less advanced CEECs) 277, 309 ‘shift of profits’ to Ireland 244(n12) small countries 195, 197 South-Eastern enlargement (prospects) 315–46 southern enlargements (1981, 1986) 185, 202 trade openness (1981–2002) 269f trade surplus with CEE 381 unilateral removal of barriers to trade against SEE 340, 343 ‘viable alternative’ to membership 244(n16) voting power 311(n16) see also EU-10

Subject Index 415 European Union budget 12, 20, 21, 149, 198, 367, 388, 391–2 agricultural 392 convergence (1992–2002) 207f deficits 153 direct payments to new members 212(n6) foreign policy 392 net contributors 367, 389, 390, 391, 393, 395 net recipients 394 obligatory contributions 302, 311–12(n16) political economy of budget after enlargement (2004) 392–3 special compensatory payments 302 European Union constitution 188, 390, 395 European Union enlargement 1–23, 372–3, 375, 383, 388, 395n ‘almost entirely to benefit of new members, not EU-15’ 354 benefits and costs (eastward enlargement) 294–303, 311–12(n13–16) challenges (four broad areas) 1–2 competition policy (Hungary) 117–45 costs to EU-15 154 criteria for inclusion ‘should be defined clearly’ 309 demand-side effects ‘neglected’ 219 economic benefits 296–301, 312(n13–14) economic costs 302–3, 311–12(n16) economic costs and benefits 2–12 economic effects on CEECs 149–84 exchange rate policy (CEECs) 49–83 experience of previous accessions and lessons for CEECs 217–72 factor movement effects (Breuss) 2 first ‘wave’ applicants, other applicants, non-applicants 303–4 four points (Lacina) 387–8 impact on countries beyond new frontiers 346–61 impact on economic disparities in CEE 275–314 income convergence 4–7 ‘left-out’ countries 305–7, 308–9, 312(n17) lessons from earlier accessions 219–45 negotiations 27 non-candidate countries 2

policy recommendations 307–10 political benefits 295–6 political dimensions 188 propositions to encourage success 365–7 quasimembership 308–9 risk of new division in Europe 307–8 role of EU in regional cooperation 309–10 single market effects (Breuss) 2 structural assistance programmes 301–2, 311(n15) supply-side effects 219 towards cohesion and unity in Europe 309–10 trade effects (Breuss) 2 triple strategy 308 ‘vulnerable to distraction and subversion’ 368 European Union enlargement as economic challenge 185–216 budgetary effects 202 costs for EU-15, benefits for CEEC-10 190, 192t, 194t, 198–200, 204, 211, 212(n5–9) direct growth effects 202 ‘exogenous shock’ 211 factor movements 190, 194t, 196–8, 204, 211–12(n2–4), 211 GDP growth convergence/volatility 206f integration (one- or two-step) 203–11, 212–13(n11–13) integration effects (real GDP, 2005–10) 194t integration effects of EU enlargement 190–203, 211–12(n2–10) macroeconomic effects (2005–10) 208–9t model inputs 193, 195, 196–7, 197–8, 199 model results 193, 195–6, 197, 198, 199–203 more winners than losers 200–3, 212(n10) OEF world macroeconomic model 189–90, 193, 194t, 196, 199, 201n, 209n, 211 possible dangers 203–11 preaccession period 198, 200 Single Market effects 190, 193–6, 200, 201, 204, 206, 211 three growth scenarios 202 trade effects 190, 191–2t, 192–3, 194, 200, 202, 204, 211 winners and losers 211

416 Subject Index European Union membership ‘anchor’ for good policy 355, 356 ‘determined by extent of reforms’ 382–3 Hungarian banking sector 103–16 ‘prize’ 382 ‘should not be automatic’ 382 European Union programmes (Erasmus, Leonardo, Socrates) 7 European Union summits/European Councils Berlin (March 1999) 149–50, 158, 186, 198, 301, 391 Brussels (‘October’) 150 Copenhagen (June 1993) 14, 77(n2), 186–7 Copenhagen (December 2002) 1, 149–50, 153, 154, 155, 157, 301, 312(n16), 388, 390, 391 Edinburgh 301 Helsinki (December 1999) 187 Laeken (December 2001) 186, 188 Nice (December 2000) 186 Seville (June 2002) 186 Thessalonica (June 2003) 391 Vienna (December 1998) 367 votes 392 European Union transfers 199, 200–1, 225, 224t, 227, 301, 374 absorptive capacity 301, 302 to CE-8 301 to Greece 226, 270f, 270, 271 to SEE 342 European Union Treaty 43, 46, 251 Euroscepticism 375 ‘excessive deficit procedure’ (EDP) 19, 46f, 46 exchange controls 248 exchange rate bands 80(n41) exchange rate crises 174, 176, 385 exchange rate index, nominal effective 60 Exchange Rate Mechanism see European Monetary System exchange rate policy 51, 169, 203, 234, 249, 253, 343, 385 case for participation in EMU 50–3 country experience 59–71 determinants of exchange rate movements 57–9 EU accession context (CEECs) 49–83 exchange rate system and macroeconomic framework 53–7 indirect market-based instruments 55

path to ERM-2 72–4 policy dilemmas 74–6, 77, 80–1(n46–51) questions 50 sovereign decisions 228, 234 exchange rate regimes 77, 163, 164, 171, 257, 262, 384 fixed 171 Portugal 247, 248–52, 262–3(n2–9) rule-based 249, 251 exchange rates 39, 58, 60(n29), 67f–71f, 188, 226, 235, 290, 361(n3) adjustable peg 54, 63 adjustment safety valve 174 appreciation 172, 248 appreciation pressures 75 competitive 228 crawling peg 54, 60, 72, 80(n34) depreciation 53, 58, 80(n37), 211 depreciation risk 50–1 devaluation 58, 63, 73 equilibrium (long- and short-term determination) 79(n26) equilibrium real 60 fiscal policy and 79(n23) fixed 53, 341, 343, 373 fixed nominal 43, 58 fixed peg 53, 57, 58, 174 fixed real 29 fixed versus flexible 50, 77(n5) flexible 54, 59, 66, 72, 80(n42) fluctuation band (Maastricht criterion) 311(n10) fluctuations 55, 59, 63, 78(n6) forward market 56 freely floating 54, 74 hard peg 65, 66 impairment of macroeconomic stabilization function 51 irreversible 174 long-term equilibrium real 57 loss of policy instrument 51, 78(n6) managed float 57, 59, 60 nominal 41, 57, 59–60, 63, 65, 74, 79(n20), 172, 221, 226 nominal effective 61–3f pegged 65, 66, 73, 80(n33), 204, 207 preannounced crawl 56, 66, 72, 78(n16), 80(n34) real 40, 41, 42, 57, 59–60, 173f, 195, 248 real appreciation 172, 221, 226, 228 real effective 44 realignments 174 revaluations 75, 77 rigidity 385

Subject Index 417 exchange rates – continued speculative attacks 53, 66, 74, 75, 76, 78(n13), 80(n40), 228, 254, 255 stability 72, 73, 74, 80(n46), 212–13(n11) volatility 59, 75, 170 executive branch/power 33, 35, 36t, 55 ‘expansionary bias’ 16–17 expatriates 320, 322 export activities 57, 223 creation 79(n25) dependence 349 developments 326 diversification 349 earnings 29 expansion 232 growth ‘essential’ (SEE) 340, 344 intensity 223 prices 98, 244(n12) revenues 230 sales 221 surplus 222, 233 exporters 221, 223, 253 exports 5, 42, 44, 191t, 193, 225, 226, 227, 228, 231, 268, 299, 319, 319f, 333, 341, 344, 347t, 351, 352 CEEC 193 CIS 349 Hungary 100(n4) Ireland 233, 244(n12) external account crises 176 factor incomes 342 intensity 326 movements 190, 192, 194t, 196–8, 200, 201, 204, 211–12(n2–4) farmers 227, 387 direct payments (from EU) 157, 388–9 FDI see foreign direct investment finance ministers 33, 34, 35t, 35–6, 374 financial crises 80(n30), 373, 376 Financial Framework (EU) 391, 392, 393–4 financial institutions 59, 77(n3), 111, 115 foreign/international 13, 106 soundness 57, 59 financial intermediation 178, 320 Financial Instrument for Fishery 311(n15) financial markets 27, 167, 190 globalization 376, 377 international 168, 171, 250, 257, 271 financial sector 14, 63, 271

financial services 249, 251 financial systems 378, 384, 385 fines 121, 131, 132, 137(n17), 139(n31, n35), 141(n52, n55), 248 Finland 15, 87, 181–2(n7), 192, 195, 203, 300t, 300, 395 fiscal consolidation 15–16, 44–5 deficits 166, 341 discipline 73, 76, 251 policy 28, 39, 40, 45, 51, 57, 58, 63, 72, 78(n7), 79(n23–5), 169–71, 290, 374 reform 30–1, 32 stabilization 27 ‘sustainability’ 166, 168, 335–8, 343 tightening 290 fish/fisheries 99, 297 fixed capital formation 156 food processing 105, 327 forecasting 260, 263(n14), 374 foreign direct investment (FDI) 2, 3, 5–6, 57, 58, 114, 133, 154, 163, 169, 175, 178, 179, 180, 190, 191t, 219–20, 221, 222, 229–34, 298–9, 299–300t, 300, 308, 311(n14), 320, 333, 339–40, 343, 344, 384 capacity to absorb 231 demand-side effects (‘tend to be neglected’) 5 diversion 357 effects of EU enlargement on CIS (left out) countries 355–7 flows 223, 225, 234, 360 flows to cohesion countries (1970–2000) 231, 231t flows from West to East 196–7, 200, 201 inflows 55, 156, 206, 223, 226, 243(n8), 271, 292, 301, 307, 335, 344(n2), 378 outward 156 per capita 355 ‘saturation point’ 234 second-order repercussions 79(n25) special incentive policies 356 stock 233 supply-side effects 5 foreign exchange 55, 322 Foreign Exchange Law (Portugal, 1989–90) 248–9, 263(n9) foreign exchange reserves 40, 41, 43, 80(n30), 249, 253 foreign investment/investors 108, 243, 298 see also foreign direct investment

418 Subject Index foreign policy 296 ‘foreign savings’ (import surplus) 230 four freedoms 187 France 21, 33, 80(n44), 88, 99, 158, 181(n7), 193, 202, 393, 395 Frankfurt 283 free-loading/free-riding 12, 100, 129 free market institutions/principles 251, 287 free movement of people 188, 368, 369 free trade 87–8, 346 free trade areas/agreements 98, 101(n12), 187, 297, 340, 386, 387 French franc 247 Gambling Act (Hungary) 140(n47) GATT (1947–) 98, 99, 203, 284, 297, 386 Article 24 96 Uruguay Round 90, 94, 96 see also WTO Gazdasági Versenyhivatal (Economic Competition Authority) 137(n16), 138(n25), 140(n49) GDP 176f, 189, 191, 191t, 207f, 219, 243(n3), 265, 266t, 271, 276, 311(n10), 323, 347t, 348 capacity to absorb FDI 231 capital inflows 221f demand side 220, 221 gains 301 import intensity 222 per employee 175 real 198, 199–200, 211 real (integration effects of EU enlargement, 2005–10) 194t, 195–6 real per capita 207 GDP deflator (1996–2002) 164f GDP growth see economic growth GDP per capita 202, 211, 234, 311(n7, n16), 347t absolute differences fail to diminish 240, 240t growth 235–40, 244(n13) growth (EU-15, CEECs, 1992–2000) 286, 287t SEE and CEE countries (2002) 316t Geary–Khamis (G–K) dollars 237–8, 238t, 239f, 240f General Electric (USA) 111 generalized autoregressive conditional heteroskedasticity (GARCH) 258–9, 260, 260t, 263–4(n13–14) Gaussian GARCH 258

Generalized System of Preferences (GSPs) 89, 93, 101(n9) generational accounting 45 ‘geographic fundamentals’ 247, 250, 253 geography 179, 271, 287, 378 geostrategic advantages 295, 296 Germany 9, 16, 33, 66, 78(n9), 158, 181(n7), 192, 197, 198, 202, 211(n2), 212(n4), 358, 381, 387, 388, 393, 395 eastern Länder 4, 80(n45), 200, 230, 243(n7), 390 gains from EU enlargement 211 integration effects (real GDP, 2001–10) of EU enlargement 201f macroeconomic effects of EU enlargement (2005–10) 208t migration from CE-8 region 8 ‘Gerschenkron’ pattern 178 globalization 118, 374, 375, 376, 377 GNP 233, 236, 239, 244(n14), 331 gold standard 263(n6) Goldman Sachs 260 government borrowing requirements 58 deficits 336 employees 79(n21) funds 131 intervention 271 paper (long-term maturities) 57, 78(n17) policy 189–90 procurement 87, 226 governments 33, 34, 108, 112, 132, 155, 250, 336, 369, 370 CEE 369, 378 coalitions 33 Greece 271 national 12, 19, 31, 288, 379 Portugal 248 single-party 33 social-democratic 375 Great Depression 376 Greece 6, 13, 15, 27, 38, 47, 51, 52, 58, 81(n51), 87, 153, 156, 158, 159, 161–2, 192, 199, 200, 205, 223, 228, 232, 234, 279, 292, 301, 303, 382, 390, 392, 395 accession to EC (1981) 265 cohesion country 226–7 delayed adjustment 265–72 economic performance (1961–2002) 265, 266t ERM 72 explanatory factors 270–1

Subject Index 419 Greece – continued external position (1970–2000) 224t external trade 269–70, 270f FDI flows (1970–2000) 231, 231t FDI flows (before and after accession) 299t, 300, 311(n14) ‘fourth Brussels directive’ 252 GDP per capita (Geary–Khamis dollars, 1950–2002) 238t, 239 GDP per capita (PPS terms, 1960–2000) 236–7, 237t, 237f GDP per capita (real growth rates, 1960–2000) 235, 236t, 236 long-term trends 265–70 losers 271 membership of EC/EU (two subperiods) 265 openness to trade 268 proportion of foreigners 268 regulatory tax 268 ‘relatively closed economy’ 268 strong opposition to EU membership, 311(n14) trade with EU 2000 (percentage of GDP) 52f value added and labour force (1998) 53f see also cohesion countries; Mediterranean-3 ‘Greece syndrome’ 385 Gross National Income (GNI) 391 Growth and Stability Pact see Stability and Growth Pact Halle: Institute for Economic Research 243(n1, n7) hard currency strategy 72–3, 75, 76 ‘hard escudo’ policy (Portugal) 248, 252 HDI see human development index health 172, 282 heavy tails 258, 263(n12) ‘Helsinki group’ (Bulgaria, Latvia, Lithuania, Malta, Romania, Slovakia) 187, 197 HERMIN-model evaluations 199–200 home savings associations 114, 115 Hong Kong 233 hotel services 134, 142(n65) household savings 114 housing market 78(n8), 174

human capital 6, 7, 10, 12, 175, 227, 276, 279, 282, 290, 348, 360 effects of EU enlargement on CIS (left out) countries 357–9, 361(n6) human development index (HDI, UNDP) 279, 280–1t, 282, 292 Human Development Report (UNDP, annual) 310(n4) human rights 186, 307 Hungarian banking sector (restructuring) 12–13, 103–16 bank-oriented loan consolidation (portfolio clean-up programme) 103, 107, 108–9 consolidation programme 108–10, 113–14 enterprise-oriented loan consolidation 103, 109 first steps of reform (1987–91) 104–6 legislative preparation for EU membership 115–16 legislative shock therapy of 1991 106–7 lessons 113–14 ‘now in line with EU standards’ 116 privatization of state banks 111–12 recapitalization of banks 103, 109–10, 112, 113 recent trends 114–15 rehabilitation (dealing with bad debts) 107–8 Hungarian Credit Bank 110, 112 Hungarian Foreign Trade Bank 104, 111 Hungarian Investment and Development Bank 108 Hungary 2, 19, 27, 28, 30, 44, 47, 51–4, 56, 66, 78(n16), 79(n19), 80(n39), 88, 89, 90, 96, 97, 100(n4), 140(n43), 149, 162t, 162, 193, 196, 197, 199, 200, 202, 206, 276, 284, 287, 290, 305, 342, 369, 395 annual net cost of sterilized interventions 78(n15) bad debt problem 107 ‘benefits likely to outweigh costs’ (ERM-2 membership) 76 budget balance (1998–2002) 167f budget process 34–8 capital account openness 54 central government deficit (1993–2002) 37t central government spending (1993–2002) 37t competition policy 13 competition policy (EU accession) 117–45

420 Subject Index Hungary – continued crawling peg regime 54 effective rates of protection 78(n14) exchange rate and interest rates (1997–9) 69f exchange rate and monetary framework (2001) 54t exchange rate policy 50 exchange rate and unit labour costs (1993–8) 62f exports 333 financial indicators (1993–9) 64t gains from EU enlargement 211 GDP (1995–2002) 177f GDP deflator (1996–2002) 164f impact of Russian crisis (1998) 66 import tariff rates 78(n14) integration effects (real GDP, 2001–10) of EU enlargement 201f integration effects of EU enlargement (real GDP 2005–10) 194t interest rates (1998–2002) 165f legal system 126 Maastricht convergence criteria 210t macroeconomic effects of EU enlargement (2005–10) 208–9t merger control 142(n69) path to ERM-2 72, 80(n39) per capita GDP (1989–2002) 240t performance indicators (1993–9) 56t real exchange rates (2000–3) 173f stabilization package (1995) 119 trade with EU 15 trade with EU (percentage of GDP, 2000) 52f transition process 137(n6) value added and labour force (1998) 53f wage drift 79(n22) see also CE-8, CEE-4, CEEC-3, CEEC-5, CEEC-7, CEEC-10, EU-18, ‘Luxembourg group’ Hungary: Competition Council 121, 130, 131–2, 137(n15), 138(n18, n25) appeals 131–2, 137(n15), 141(n52, n55) ‘arm of the OEC’ 121 caseload (1991–2002) 122–4, 127–9, 132, 139–40(n34, n38–39, n41), 141(n52) structure of decisions 124–5 Hungary: EU accession and competition policy 117–45 blanket clause 121, 123, 125, 126–7, 137(n18), 138–9(n29–36), 140(n40)

caseload 121, 122–4, 137–8(n17–18, n21–6) changes in competition law induced by Europe Agreement 120–1, 137(n9–15) ‘competition advocacy’ 138(n21) consumer deception 123, 127–31, 139–40(n33, n37–50) ‘creative’ and ‘supportive’ tasks 133 effectiveness of competition policy 131–4, 140–2(n51–72) ‘functional’ explanation 133, 141–2(n61–3) laxity 134 legal and institutional development 118–21, 137(n4–15) ‘market structure’ explanation 133–4, 142(n64–7) merger decisions 135–6t moving targets 117 structural change 124–5, 138(n27–8) structure of competition policy cases 121–5, 137–8(n16–28) ‘supervision of competition’ 122, 138(n21) ‘transitology’ explanation 132–3, 141(n57–60) transition-oriented competition policies 119–20, 137(n6–8) transitional elements of competition policy 125–31, 138–40(n29–50) Hungary: Ministry of Finance 106, 119 Hungary: Office of Economic Competition (OEC) 120, 121, 128–32, 139(n38) budgetary resources 131, 141(n55) competitive pressure and legal pressure 130 political independence 132–3 questions of economic policy relevance 132 responsible to parliament 138(n20) role in privatization 133, 141(n59) structure of merger decisions (1991–2001) 135t, 142(n68) Hungary: Office of Prices and Materials 124 Hungary: State Property Agency 106 ICCTI-EHESS project 262(n1) Iceland 122 import barriers 299 competition 134 prices 355 requirements 223

Subject Index 421 import – continued substitution 79(n25), 232 surcharges 138–9(n31) surplus 220, 222, 225, 226, 227, 229, 230, 232 ‘import of unemployment’ 230 importers 221, 223 imports 5, 29, 90, 133, 138(n25), 191–2t, 193, 221, 225–8, 234, 243, 268, 340, 341, 361(n3) Ireland 244(n12) machinery and equipment 58 SEE 333 income 7, 180, 222 changes 351 distribution 279 EU-15 versus accession countries 3 growth 354 inequality 3, 221–2, 282, 311(n9), 326 levels 166 index of socioeconomic development (Adelman and Morris, 1967) 310–11(n7) Indonesia 376 industrial concentration 182(n8) cooperation 154 countries (major) 78(n18) organizations 326 sector 105 structure 385 industrialization 242, 275–6 deindustrialization 323, 344(n2) industry 302, 370 capital-intensive 179f, 330 high-skill 331 labour-intensive 179f, 330 low-skill 331 mainstream 179f, 330 marketing-driven 179f policy 240 specialization 78(n12) structure 271 technology-driven 179f three-digit NACE level 326 weakness (SEE countries) 323, 326 infant industries 242 infant mortality 279, 280–1t inflation 17, 18, 29, 40, 41, 43, 44, 53, 54–9, 65, 80(n32, n37), 121, 164, 172, 188–9, 221, 234, 246, 249, 255, 265–7, 267f, 290, 291t, 308, 309, 311(n10), 377 convergence in run-up to EMU (1992–2002) 204f forecasts 79(n21)

nominal rate 73 rate 75, 169, 171 targeting 74, 80(n41), 171 volatility 204, 205f inflationary pressures 73, 248 informal economy 319, 331, 332t, 339, 340, 341 information, free flow 277, 288 information technology 94, 375, 376 infrastructure 10, 57, 105, 156, 166, 175, 180, 276, 338, 389 bottlenecks 174 investment 199 public investment rates 5 initial conditions 202, 276, 287, 348–51, 378 Institutional Investor 311(n13) institutions 2, 10, 117, 175, 243, 309, 288, 343, 342, 371, 377, 378, 379 absorption capacity 10, 11, 380 budgeting and credible MAFAS 30–8 common pool problem (mitigation) 33 developments 180, 331 EU accession and competition policy (Hungary) 118–21, 137(n4–15) framework 50 international comparisons 38 legitimacy and accountability (EU) 374 macro evaluation framework 38–46 macroeconomic policy during transition to EU membership 27–48 reform (EU) 380 role 12–13 role in market transformation 284, 310(n6) rules 30–1 insurance 223 insurance (political benefit) 95, 96 intellectual property legislation 139(n35) interest (payments) 121 interest rates 39, 40f, 41, 52, 53, 66, 67f–71f, 72, 74, 165f, 167, 168, 188, 190, 197, 211–12(n2), 229, 250, 290, 311(n10), 333 adjustments 58 differentials 171, 263(n7) convergence 205 domestic 56 fixed rate 260 floating 260 nominal 164–5

422 Subject Index interest rates – continued real 43, 262(n4), 263(n7) short-term 65, 80(n33) intergenerational equity 166 Intergovernmental Conference (EU, 2004) 188, 395 Interinstitutional Agreement on the Framework 392 International Institute for Strategic Studies (London) 376 International Migration 361(n6) International Monetary Fund (IMF) 77(n1), 243, 248, 250, 360(n1), 382 Article VIII status 54 structural adjustment programme 46f, 46 internet hosts 279, 280–1t, 282 investment 39, 40f, 114, 166, 175, 231, 290, 309, 344, 348, 359 brownfield 219 domestic 220, 221, 222, 225 greenfield 219 imported 243(n3) income effect 220 national accounting sense 219, 220 public 20, 157 real 225 see also foreign direct investment investment banking 116 investor confidence/sentiment 63, 75 investors 12, 111, 112, 114, 250, 253 Ireland 6, 15, 16, 38, 51, 75, 81(n51), 141(n56), 158, 193, 195, 200, 202, 228, 253, 266, 271, 282, 385, 392, 395 cohesion country 225–6 competitive structures 142(n64) external position (1970–2000) 224t FDI flows (before and after accession) 299t, 300 FDI flows (1970–2000) 231, 231t, 232, 244(n10) foreign businesses (sectoral concentration) 233 foreign firms 233 GDP per capita (Geary–Khamis dollars, 1950–2002) 238, 238t GDP per capita (PPS terms, 1960–2000) 236, 237t, 237f GDP per capita (real growth rates, 1960–2000) 235, 236t, 236 GDP–GNP relationship 233 ‘growth miracle’ 181 non-manufacturing activities 233, 244(n11) per capita GDP 234

Regional Fund 390 successful catching-up 4 trade with EU 2000 (percentage of GDP) 52f US-dominated FDI 232–3 value added and labour force (1998) 53f see also cohesion countries Irish Life Insurance Company 112 ‘Irish option’ 365, 366 ‘irrational exuberance’ 376 Islam 304, 307, 312(n17), 338 ISPA (pre-accession fund) 10, 187 Italy 38, 51, 58, 73, 78(n6), 79(n23), 80(n36, 38), 153, 158, 174, 192, 193, 200, 205, 385, 392, 393, 395 catching-up process 238t, 239 ERM 72 gains from EU enlargement 211 integration effects (real GDP, 2001–10) of EU enlargement 201f macroeconomic effects of EU enlargement (2005–10) 208t ‘Objective 1 regions’ 181(n7) trade with EU 2000 (percentage of GDP) 52f value added and labour force (1998) 53f J.P. Morgan 260 Japan 79(n18), 87, 95, 101(n13), 299, 375 justice agenda 392 Kaliningrad region 21 Kazakhstan 201n, 349, 356, 357 Kluwer Academic Publishers 47n Kosovo 303, 304, 318, 340, 341, 342, 339 Kredietbank (Belgium) 112 labour 52, 53f, 174, 195, 197, 198, 326, 348, 381 effects of EU enlargement on CIS (left out) countries 357–9, 361(n6) free movement 8, 9, 298 low- to medium-skilled 358, 360 misallocated 339 not fully utilized 220 organized 60 skilled 178 temporary 357, 358, 360 labour costs 60, 234 Labour Force Surveys 319, 339

Subject Index 423 labour markets 3, 7, 8, 20–1, 51, 169, 170, 178, 181, 212(n4), 339 flexibility 2 problems 385 winners and losers 189, 388 labour migration 180, 190, 267–8, 271 labour mobility 8, 21, 51, 78(n8), 169, 174, 201 five options 212(n4) safeguard clauses 9 land 171, 180 Laspeyres and Paasche quantity indices 235 Latin America 47, 72, 79(n24) Latvia 4, 89, 101(n11), 287, 382–3 budget balance (1998–2002) 167f GDP (1995–2002) 177f GDP deflator (1996–2002) 164f interest rates (1998–2002) 165f Maastricht convergence criteria 210t trade with EU 15 see also CE-8, CEEC-10, ‘Helsinki group’ law 117 civil/tort 125, 128, 129, 138(n28), 140(n41–2) commercial 127, 131 enforcement 13, 114, 121, 371 EU 5 EU accession and competition policy (Hungary) 118–21, 137(n4–15) harmonization 298 homogeneity (EU) 372 ‘left-out’ countries 294, 303, 305–7, 308–9, 312(n17), 387 impact of EU enlargement 346–61 ‘may not appreciate’ being so designated 346 potential problems 305–7, 312(n17) legal systems 125, 126, 127, 129, 138–9(n28, n30, n36) lessons (earlier EU enlargements) 219–45 convergence of cohesion countries with EU average 235–43, 244(n13–16) external position of cohesion countries 219–35, 243–4(n3–12) influence of capital inflows on GDP 219–35, 243–4(n3–12) Levine–Renelt growth equation 291–2 liberalization 38, 252, 309 direct investment 75 external 75, 81(n48) financial 248 imports 133 macroeconomic 287 trade and capital 118 life expectancy 279, 280–1t

lifelong learning 6, 7 lira 253, 260 Lisbon agenda 392 literature ‘blanket clause’ 125 budget process 31 consumer deception/fraud 128(n23) convergence 175 eastward enlargement 219 economic growth 290 economic integration effects 347 EU enlargement 3, 294 functional explanation (competition policy) 133, 142(n63) growth 175 supply-side impact of FDI 178 third-party effects 349 transition (early) 133, 141(n62) transition (mainstream) 118 transition countries 356 transition-related competition policy 118 Lithuania 89, 101(n11), 149, 286, 292 budget balance (1998–2002) 167f GDP (1995–2002) 177f GDP deflator (1996–2002) 164f interest rates (1998–2002) 165f Maastricht convergence criteria 210t see also CE-8, CEEC-10, ‘Helsinki group’ living standards 279, 280–1t, 288, 295, 302 Ljung-Box test 263(n12) log-likelihood function 259, 260, 263(n13) Lomé Convention 101(n9), 368 London 283, 390 Luxembourg 122, 182(n7), 279, 383, 389, 391 ‘Luxembourg group’ (Cyprus, Czech Republic, Estonia, Hungary, Poland, Slovenia) 187, 197, 198 luxury goods 222, 226 Maastricht Treaty 14, 22(n2–3), 75 Article 109: 81(n47) convergence criteria 17–19, 168, 171, 190, 203, 205, 210t, 255, 267, 290, 291t, 311(n10), 389 Protocol on the Transition to the Third State of Economic and Monetary Union 14, 22(n2) Macedonia 21, 282, 288, 292, 305, 315, 327, 331, 340–2, 344(n4), 391 Albanian minority 303 civil war (2001) 318 see also CE-7, SEE-4

424 Subject Index macroeconomic adjustment 60 conditions/environment 16, 111, 114 indicators 119, 131 instruments 53 performance 196 stability 77, 167, 172, 189, 333–9, 342, 380 stabilization 50, 73, 267, 271, 287, 288, 308–9, 377 macroeconomic evaluation framework 38–46 application to CE economies 40–2 balance sustainability (external/internal) 45, 46f, 46 debt sustainability 42–3, 45 policy assignment 38–40 policy matrix applied to CE countries 43–6 targets and instruments 39, 40 macroeconomic policy 2, 25–83, 202, 246, 248, 251, 253, 255, 257, 308, 373 accession of new-member countries to EMU 13–20, 22(n2–4) effectiveness 13 EU guidelines 166 exchange rate policy challenges 164 exchange rate policy in EU accession context (CEECs) 49–83 implications of EU membership for CEECs 163–74 institutions during transition to EU membership 27–48 monetary policy challenges 164 structural problems 174 ‘macroeconomic productivity’ 175, 176f MAFAS see multi-annual fiscal adjustment strategy Malta 149, 156, 162t, 162, 185, 186 Maastricht convergence criteria 210t see also accession countries; ‘Helsinki group’ manufacturing 52, 60, 78(n10), 92, 119, 175, 176f, 176, 178, 223, 320 exports 327, 330–11 goods 101(n11), 226, 233, 297, 352 value added and labour force (1998) 53f market access 154, 343, 368 behaviour 126, 139(n33) concentration 121, 134 creation 133, 141(n61–2) distortions 133 disturbance 129 dominance 134

forces 180 information, imperfect 247 institutions 276, 283, 284 integration 340 liberalization 370 microstructures 139(n38) niches 134, 142(n67) reforms 287, 303, 309, 360 services 178 share 115, 137(n10), 138(n25) system 284 market economies 27, 50, 100(n7), 124, 125, 129, 132, 133, 138(n21), 139(n33, n35, n38), 142(n67), 166, 186, 203, 284, 341, 358, 377, 378 competition law 119 legal framework 118 marketing 297, 327 markets buyers’ 127 deregulation 308 effective 117 emerging 59, 99, 190, 373, 377 global/world 243, 381 ‘hit-and-run’ entries 140(n46) international 308 large domestic 357 local 223 product, labour, capital 331, 332 proper functioning 140(n51) sellers’ 127 smoother functioning 125 widening 134 markka 260 ‘matching funds’ 302 mean absolute error (MAE) 260 mean square error (MSE) 260, 260t, 263(n14) Mediterranean partnership countries 346, 354, 355, 359, 361(n5) Euro-Med Agreements 94 Southern Mediterranean 368 Mediterranean products 227 Mediterranean region 58 Mediterranean-3 (Greece, Portugal, Spain) 3, 5, 6 see also cohesion countries ‘merger authorization’ 124 merger control 119, 120, 122, 124, 128, 133–4, 137(n12), 142(n69, n71–2) Competition Council’s caseload (Hungary, 1991–2002) 123f, 125 EU practice 138(n26) ‘failing company defence’ 142(n66) ‘per se’ treatment 142(n70) ‘rule of reason’ approaches 134, 142(n70)

Subject Index 425 mergers 219–20 Mexican crisis (1994) 376 Mezõbank (Hungary) 110 Mezzogiorno 4, 180, 390 middle class 378 Middle East 392 migration 2–3, 7–10, 12, 192t, 338, 358, 360 East to West 197–8, 200, 201 illegal 9–10, 358, 361(n6) models calibrated two-bloc (EU-15, CEEC-10) 202 CGE (computable general equilibrium) trade effects of EU enlargement on CIS countries 351–5 CGE (computable general equilibrium), ‘WorldScan’ 202 general equilibrium 301 macroeconomic simulation (EU/CEECs) 300–1 Mundell–Fleming 58, 189 partial and general equilibrium 187–8 projected long-term economic growth 290–1 QUEST II 200 world CGE 201–2 world macroeconomic 2, 202 Moldova 21, 279, 287, 304, 305, 306, 310, 346, 386 see also CIS-4 monetary policy 28–30, 39, 45, 51, 57, 58–9, 79(n26), 169, 205, 211, 249, 250, 252, 290, 343, 374 monopolies 117, 124, 133, 134, 138(n21), 341 monopolistic competition, theory of 195 Montenegro 304 see also Serbia-Montenegro Moody’s Investor Services 253 moral hazard 9, 113 Moscow 140(n45) most-favoured nation (MFN) principle 89, 91f, 94, 96–9, 100(n6), 386 MSE (mean square error) 260, 260t, 263(n14) multi-annual fiscal adjustment strategy (MAFAS) 16, 27, 29, 39, 43–4, 46f, 46, 47, 248–51, 255 budget process 30–8 Mundell–Fleming model 58, 189 national accounts 35t, 36 National Bank of Hungary (NBH) 77(n1), 103, 104, 106, 108, 112

National Bank of Poland 310(n1) National Deposit Insurance Fund (Hungary) 104, 115 National Savings and Commercial Bank (Hungary) 104, 109, 111 National Savings Co-operatives Institution Protection Fund (Hungary) 109 national security 295, 307 nationalism 275, 295, 305, 374 nationalization 106 NATO 51, 73, 275, 276, 294, 296, 305, 307 natural resources 349, 356, 357 ‘near abroad’ 366, 392 neoclassical theory 290 net factor income from abroad (NFIfA) 225, 233 Netherlands 38, 181(n7), 193, 202, 395 ‘New Europe’: political and economic challenges (panel discussion) xviii, 365–96 asymmetry or reciprocity 369 blocking minorities in enlarged EU 394–5 budget 391–2 CAP dimension 388–9 ‘Club Med’ v. ‘new kids on block’? 393 eastward enlargement (propositions to encourage success) 365–7 hub-and-spoke or multilateralism 369, 386 narrow or wide-angle lens 369–70 new ‘Club Med’? 392–3 new members v. candidates 393 observations about previous experiences and current context 367–8 political economy of budget after enlargement (2004) 392–3 shadows of past versus shadow of future 368–9 structural funds 389–90 tipping balance in favour of successful enlargement 368–70 weighted voting after 2009 395 weighting of votes in European Council 394 new processes/products 231 Nice Treaty (December 2000) 186 Nigeria 357 non-debt-creating capital inflows 219 non-factor services 44, 220 non-profit organizations 120

426 Subject Index non-tariff barriers (NTBs) 78(n14), 92–3, 94, 98, 99, 100(n7), 226, 268, 340 non-tradable sector 58, 171–2, 176, 211, 277 North Africa 392 North American Free Trade Area (NAFTA) 9, 192 Nova Economics Working Paper No 346 262(n1) nuclear safety 302 OEC see Hungary: Office of Economic Competition OECD see Organisation for Economic Co-operation and Development off-budget funds 35t, 37 Office of Fair Trading (UK) 140(n42) oil 205, 356 Opel Hungary Ltd 138–9(n31) open economies 80(n41) ‘open societies’ (Popper) 377 optimum currency area (OCA) 15, 50, 51, 169–70, 174, 203 Organisation for Economic Co-operation and Development (OECD) 51, 54, 115, 116, 122, 189, 243, 275, 284, 310(n4), 369 Organization for Security and Co-operation in Europe (OSCE) 346, 373 organized crime 307 Orthodox Christianity 304, 312(n17) output 15, 78(n10), 176, 338, 340 outward processing traffic (OPT) quotas 93–4, 100(n8) own resources 150, 151–2t, 157, 163, 199, 391, 392 Oxford Economic Forecasting (OEF) world macroeconomic model 189–90, 193, 194t, 196, 199, 201n, 209n, 211 Pan-European Free Trade Area (PEFTA) 386 Paris 283 parliaments/legislatures 36t, 47, 55, 249, 250, 263(n6), 294 bicameral systems 33, 35 budget process 33–4 Czech Republic 141(n58) unicameral systems 33 upper houses 33 votes of confidence 33, 35t partial integration effect 204 peace dividend 338

pensée unique (economic orthodoxy) 373 pension funds 111, 114 pensions 9, 45, 73, 342, 338 peripheral areas 78(n6), 180, 310(n5), 378 peseta 228, 246, 247, 249, 250, 252, 253–4, 257, 260, 261t Petrogal 263(n9) Phare programme 10, 187 physical capital 4, 12, 227 PIN (potential for instability) index 288–9, 289t, 311(n9) piracy 139(n35) Poland 2, 4, 19, 21, 27–8, 30, 47, 51–3, 56, 60, 80(n39), 88–90, 96, 140(n43), 149, 161, 162t, 162, 193, 196, 197, 199, 200, 202, 206, 276, 284, 286, 287, 290, 316, 318, 357, 358, 369, 393, 395 bad debt problem 107 ‘benefits likely to outweigh costs’ (ERM-2 membership) 76 budget balance (1998–2002) 167f budget process 34–8 capital account openness 54 catch-up timespan 242 central government deficit (1993–2002) 37t central government spending (1993–2002) 37t competitiveness (indicators, 2001) 328f contribution to EU budget 312(n16) current account (percentage of GDP, 2002) 322f effective wage indexation 79(n22) employment growth (1990–2001) 317f employment structure (2001) 325f exchange rate and interest rates (1997–9) 67f exchange rate and monetary framework (2001) 54t exchange rate and unit labour costs (1993–8) 61f exchange rate adjustments 78(n16) exchange rate policy 50, 66 exchange rate realignments 174 exchange rate regimes 54 exports (1990–2001) 319f external account and exchange rate crises (2001–2) 176 FDI by sector (2001) 321t financial indicators (1993–9) 64t

Subject Index 427 Poland – continued financial transfers from EU budget 153 gains from EU enlargement 211 GDP (1995–2002) 177f GDP deflator (1996–2002) 164f GDP structure (2001) 325f impact of exogenous currency crises 66 import tariff rates 78(n14) integration effects (real GDP, 2001–10) of EU enlargement 201f, 201n integration effects of EU enlargement (real GDP 2005–10) 194t interest rates (1998–2002) 165f labour productivity (1990–2001) 327f ‘leap’ to market economy 355 Maastricht convergence criteria 210t macroeconomic effects of EU enlargement (2005–10) 208–9t merger control 142(n69) MFN and Europe Agreement tariffs (1991–2000) 91f path to ERM-2 72, 74, 80(n39) per capita FDI stock (1990–2001) 320f per capita GDP (1989–2002) 240, 240t performance indicators (1993–9) 56t preferential average concessions (1991–2000) 94f, 100–1(n9) quotas 101(n13) real exchange rates (2000–2003) 173f real GDP growth (1990–2001) 317f shadow economy (1999–2000) 332t sterilized interventions 78(n15) trade with EU 15 trade with EU (percentage of GDP, 2000) 52f trade balance (percentage of GDP, 2001) 322f unit labour costs (1990–2002) 328f value added and labour force (1998) 53f wages (1990–2002) 327f see also CE-8, CEEC-3, CEEC-5, CEEC-7, CEEC-10, EU-18, ‘Luxembourg group’ Polgári Bank 111–12 political benefits 295–6 freedom 250 instability/unrest 305, 331, 384 parties 178, 246, 247, 263(n6) stability 242, 244(n16), 246, 255, 263(n6), 288–9, 300

political economy 32–4, 368, 378, 390, 393 basic claim 30–1 EU budget after enlargement (2004) 392–3 Ponzi schemes (pyramid games) 129, 140(n47) population 191t, 290, 347t, 348 Portugal 6, 38, 47, 81(n51), 87, 153, 156, 158, 159, 161–2, 174, 199, 200, 202, 205, 223, 228, 232, 234, 266, 292, 301, 390, 392, 395 budget (1994) 250 cabinet reshuffle (1989) 263(n8) cabinet reshuffle (1993) 250, 263(n8) cabinet reshuffle (1997) 251 cohesion country 227 convergence programme (Q2) 249, 250, 253 EC accession (1985) 255, 262(n2) ERM crisis (Portugal) 252–5, 256t, 263(n10–11) external position 224t, 227 FDI flows (before and after accession) 299t, 300 FDI flows (1970–2000) 231, 231t finance minister 248, 250, 251 finance minister/central bank governor duos 246, 249, 250, 251, 255, 257, 263(n7, n10–11) ‘fourth Brussels directive’ 252 GDP growth rate 227 GDP per capita (Geary–Khamis dollars, 1950–2002) 238t, 239 GDP per capita (PPS terms, 1960–2000) 236–7, 237t, 237f GDP per capita (real growth rates, 1960–2000) 235, 236t general election (1987) 246 general election (1991) 246, 248, 249, 257, 263(n8) general election (1995) 246, 247, 263(n8) local elections (1989) 248 local elections (1993) 250, 251 local elections (1997) 251 losses from EU enlargement 211 moving escudo into euro 246–64 political stability (1987–) 246, 255, 263(n6) recession (1993) 251 Revolution (1910) 262(n2) Revolution (1974) 227, 262(n2) social democrat business elite 253 socialist opposition 253

428 Subject Index Portugal – continued trade with EU 2000 (percentage of GDP) 52f value added and labour force (1998) 53f weekly escudo/Deutschmark rate (stochastic properties) 247 see also cohesion countries; Mediterranean-3 pound sterling 225, 249, 253 poverty 180, 280–1t, 282, 288, 310(n4), 311(n9) PPERR see pre-pegging exchange rate regime PPP (purchasing power parity) 278t, 279, 292, 310(n3), 361(n3) constant 237 PPS 241t, 266 pragmatism 309, 379 pre-pegging exchange rate regime (PPERR) 27, 29, 39, 43–4, 46f, 46, 47, 248, 249, 251, 255 precedents (law) 126, 129 preferential average concessions 94, 94f, 95 preferential trade agreements (PTAs) 98–9, 101(n14) price adjustments 80(n46) competition 190, 195, 196, 200 convergence 171, 205 indexation 79(n22) level 57, 79(n20), 196 liberalization 53, 377 monitoring and correction 122, 124, 138(n21) stability 16, 56, 80(n43, n46), 203, 204, 248, 343 system 235 wars 138(n25) price-fixing 138(n25) prices 97–8, 193, 195, 297 constant 237 domestic 323 relative 385 world market 370 pricing, ‘competitive’ 118, 137(n3) prime ministers 33, 34, 247 principal component analysis 310(n7) private sector 28, 45, 79(n21–2), 168, 338, 339, 340–1 privatization 5, 12–13, 28, 29, 30, 59, 65n, 72, 103, 105, 106, 108, 110, 119, 125, 133, 141(n59), 219, 222, 231, 234, 248, 263(n9), 266, 271, 287, 298, 308, 320, 341, 377, 384

ex post judgements (Hungary) 123 lessons 113–14 state banks (Hungary) 111–12 Privatization Act (Hungary) 141(n59) problem assets 110 product markets 169, 170, 181 product quality 222, 326, 344(n2), 357 product/process standards 367 production 212(n7), 222, 230, 299, 388 costs 297, 298 cross-border networks/international networking 178, 298, 306 horizontal rather than vertical differentiation 170 structures 169 productivity 5, 17, 18(box), 19, 55, 57, 60, 63, 65, 72, 73, 76, 79(n18), 79(n20), 166, 171, 172, 175, 176f, 191, 191t, 193, 200, 211, 222, 326, 327f, 338, 344(n2) shocks 195–6, 204 productivity bias 60, 74, 75 profits 79(n25), 105, 198, 233, 244(n12) property rights 12, 114 protection: nominal and effective rates 54, 78(n14) protection money 140(n45) protectionism 88, 89–90, 92, 97, 99–100, 100(n5), 226, 240, 242, 270, 271, 297, 305, 379, 389 public administration 251, 371 public aid: EU rules 5 public expenditure 44–5, 168, 338 ‘misused’ (SEE) 343 public finances 308, (SEE) 336 public opinion 381, 382 public sector 28, 44, 45, 79(n21), 168, 251, 338, 341 deficits 72, 76, 77(n3) indebtedness 63 Portugal 248 public security 302 public transport 172 publishing company 139(n33) punt 225, 260 purchasing power standards (PPS) 236–7 Qualified Majority Voting (QMV) 389, 392–3, 395 QUEST II model 200 quotas 97, 99, 101(n13), 155, 212(n4), 340 ratios 224t capital–labour 290 current account–GDP

223, 225

Subject Index 429 ratios – continued debt service–exports 334–5t, 335 debt–exports 333, 334t, 335 debt–GDP 43, 58, 66, 166, 229–30, 311(n10), 333, 334t, 335 debt–output 29 deficit–GDP 167, 168, 311(n10) domestic investment–GDP 223, 225 domestic savings–GDP 220, 222, 223 EU transfers–GDP 225 external debt–reserves 334–5t FDI stocks–GDP 231, 232f, 232, 243(n8–9) foreign profits–GDP 243(n9) GNP–GDP (Ireland) 233 government consumption–GDP 292 investment–GDP 292 profits–FDI 243(n9) public expenditure–GDP 335–6, 338 seigniorage–GDP 43 trade–GDP 223 trade balance–GDP 225 raw materials 94, 352, 353, 355 real exchange rate index relative price-based (CPI-based) 60, 61–3f, 65, 79(n28) unit-labour cost-based (ULC-based) 60, 61–3f, 63, 65, 79–80(n28) recession 78(n7), 166, 168, 249, 251, 288, 303, 374–5 Hungary 106–7, 109 macroeconomic 318 redistribution 180, 189, 195 reform 287–8, 382–3 structural 20–1 regional development 378 disparities 180 free trade areas 187 funds 389 integration 175, 188, 309, 343, 374 policy 3, 5, 7, 10–12, 170, 180, 390 projects 156 structural policies 12 trade agreements/arrangements 96, 386 regions 22(n1), 159, 161, 162t, 178, 238 religion 312(n17) relocation, industrial 3, 6 remittances 320, 322, 324t, 333, 342, 357 rents 172 repair of aircraft 327

reputation 129, 138(n22), 246, 252, 253, 257 research and development (R&D) 10, 392 resource allocation/misallocation 338, 340, 344(n3), 377 ‘rest of world’ 190, 197, 229, 230, 347 restoration rule 74, 80(n44) restructuring 65, 66, 72, 75, 80(n46), 302, 341, 377–8 budgetary costs 73 commercial banks 59 corporate 166, 176 costs 336 Czech economy 76 economic 53, 266, 267, 270, 271, 370 enterprise 30, 63, 107, 113, 340 financial institutions 110 financial sector 73 Hungarian banking sector 103–16 industrial 57 problematic sectors 308 public sector 338 restructuring expenditure 157 retail trade/retailers 124, 138(n25), 223 protection money 140(n45) revised convergence programme (PCR) 250, 251 risk 41 country analysis 311(n13) currency 58, 299 depreciation 50–1 economic 298, 301 exchange rate 299 investment 298 new division in Europe 307–8 perceptions 59 political 298, 301, 311(n13) risk premia 16, 50–1, 73, 74, 58, 59, 66, 190, 197, 356, 357, 384 Romania 88, 90, 101(n14), 159, 162n, 162, 276, 287, 293, 298, 301, 303, 315–19, 323, 326, 340, 342, 348, 369, 391, 393, 394 balance of payments structure (percentage of GDP, 2001) 323t competitiveness (indicators, 2001) 328f current account (percentage of GDP, 2002) 322f employment growth (1990–2001) 317f employment structure (2001) 325f exports (1990–2001) 319f

430 Subject Index Romania – continued exports to EU (1997–2001) 329f, 330f external debt indicators (2001–3) 334t FDI by sector (2001) 321t GDP structure (2001) 325f general government data (2001–3) 337t government spending on wages and salaries (2001–3) 337t Hungarian minority 305 integration effects (real GDP, 2001–10) of EU enlargement 201n labour productivity (1990–2001) 327f Maastricht convergence criteria 210t merger control 142(n69) per capita FDI stock (1990–2001) 320f real exchange rates (2000–2003) 173f real GDP growth (1990–2001) 317f shadow economy (1999–2000) 332t subsidies and transfers (2001–3) 338t trade balance (percentage of GDP, 2001) 322f unit labour costs (1990–2002) 328f wages (1990–2002) 327f see also CE-7, CEEC-7, CEEC-10, ‘Helsinki group’ rule of law 6, 12, 125, 139(n32), 186, 288, 295, 304, 309, 341 rules of origin 98 rural development 153, 155, 156, 389 Russia 21, 95, 287, 304, 306, 309, 310(n2), 346, 349, 356, 357, 358, 377, 383–4, 386, 392 currency crisis (August 1998) 65–6, 74, 76, 80(n33), 176, 348, 376, 384 Euro-Asiatic 296 exports to EU 355 integration effects (real GDP, 2001–10) of EU enlargement 201n real exchange rates (2000–2003) 173f see also CIS-4; Soviet Union safeguard clauses 212(n4) SAPARD (preaccession fund) 10, 187 Sapir Group 390 Savings Cooperative Bank (Hungary) 112 savings cooperatives 108 Scandinavia 197

sectoral issues 85–145 banking sector (Hungary) 103–16 competition policy (Hungary) 117–45 European trade policies 87–102 Securities Act (Hungary, 1997) 116 security 95, 288–9 SEE see South-Eastern Europe SEE-4 countries (Bulgaria, Croatia, Macedonia, Serbia-Montenegro) balance of payments structure (percentage of GDP, 2001) 323t competitiveness (indicators, 2001) 328f current account (percentage of GDP, 2002) 322f employment growth (1990–2001) 317f employment structure (2001) 325f exports (1990–2001) 319f exports to EU (1997–2001) 329f, 330f, 330–1 external debt indicators (2001–3) 334–5t FDI by sector (2001) 321t GDP structure (2001) 325f general government data (2001–3) 336–7t government spending on wages and salaries (2001–3) 337t labour market indicators (2002) 318t labour productivity (1990–2001) 327f per capita FDI stock (1990–2001) 320f real GDP growth (1990–2001) 317f, 318 relations with EU (current situation) 342 shadow economy (1999–2000) 332t structural economic weakness 320 trade balance (percentage of GDP, 2001) 322f unit labour costs (1990–2002) 328f wages (1990–2002) 327f see also Balkan countries; CE-7 countries; South-Eastern Europe ‘seeking refuge in government’ 132 seigniorage 43 sensitive sectors 92, 95, 100(n9), 192 Serbia-Montenegro 304, 315, 318, 323, 331, 335, 340–2, 344(n4) see also SEE-4 services 87, 99, 119, 211, 323, 335, 341, 370 Greece ‘net exporter’ 270 SEE 333 value added and labour force (1998) 53f

Subject Index 431 SGP see Stability and Growth Pact ‘shock therapy’ 288 shocks 15, 57, 59, 65, 66, 77–8(n6), 168, 176, 377, 379 asymmetric 51, 52, 76, 78(n7, n9, n12), 169, 170, 174, 189, 195, 204, 211 contagion effects 59, 79(n27) faster transmission 170 supply-side 204 Singapore 233 Singapore Information Technology Agreement (1996) 94 Single European Act (1987) 76, 81(n51), 374 Single Market 21, 73, 120(n8), 187, 189, 192, 203, 249, 369, 371, 386 effects of EU enlargement 190, 193–6, 200, 206, 211 financial services 251 four freedoms 3, 196 macroeconomic impact (CEEC accession) 204 skills 6, 7, 179f Slovakia 27, 28, 30, 44, 47, 89, 90, 97, 140(n43), 149, 162t, 162, 290, 301, 320, 348, 357 bad debt problem 107 budget balance (1998–2002) 167f budget process 34–8 central government deficit (1993–2002) 37t central government spending (1993–2002) 37t competition authorities 132 customs union with Czech Republic 101(n12) exchange rate realignments 174 external account and exchange rate crises (1999–2000) 176 GDP (1995–2002) 177f GDP deflator (1996–2002) 164f impact of exogenous currency crises 80(n33) interest rates (1998–2002) 165f Maastricht convergence criteria 210t merger control 142(n69) per capita GDP (1989–2002) 240t real exchange rates (2000–2003) 173f see also CE-8, CEE-4, CEEC-5, CEEC-7, CEEC-10, ‘Helsinki group’ Slovenia 4, 51, 53, 55, 57, 60, 78(n9), 88, 90, 149, 159, 161, 162t, 166, 276, 279, 287, 290, 292, 342, 382 agricultural subsidy system 155 bad debt problem 107

‘benefits likely to outweigh costs’ (ERM-2 membership) 76 budget balance (1998–2002) 167f catch-up timespan 242 effective rates of protection 78(n14) exchange rate and interest rates (1997–9) 70f exchange rate and monetary framework (2001) 54t exchange rate policy 50, 66 exchange rate and unit labour costs (1993–8) 61f financial indicators (1993–9) 65t GDP (1995–2002) 177f GDP deflator (1996–2002) 164f import tariff rates 78(n14) integration effects (real GDP, 2001–10) of EU enlargement 201n interest rates (1998–2002) 165f Maastricht convergence criteria 210t merger control 142(n69) path to ERM-2 72 per capita GDP (1989–2002) 240t performance indicators (1993–9) 56t real exchange rates (2000–2003) 173f subsidies and transfers (2001–3) 338t trade with EU 2000 (percentage of GDP) 52f value added and labour force (1998) 53f wage indexation 60, 79(n22) see also CE-8, CEE-4, CEEC-5, CEEC-7, CEEC-10, ‘Luxembourg group’ SMEs 166, 340, 341 smoothed probabilities 259, 261t, 261–2 social capital 12, 276, 288 conflict/unrest 282, 288 expenditure 9 policy (EU) 170 security 169, 338 standards 9 welfare 3 solidarity, philosophy of 161 South-East Asia 78–9(n18), 175, 181 South-East Economic Cooperation (SEEC) 310 South-East Europe (SEE) 315–46, 366–7 access to EU markets 343 basic indicators (2002) 316t ‘development trap’ 332 employment 317f, 338–9 European integration 341–4 exports 333

432 Subject Index South-East Europe (SEE) – continued external debt indicators (2001–3) 334–5t ‘falling behind’ 318, 323, 331–2 foreign debt 333–5 fiscal sustainability 335–8 general government data (2001–3) 336–7t macroeconomic stability 333–9 private transfers (2000–1) 324t prospect of EU accession (importance) 332 real GDP growth (1990–2001) 317f sources of growth 339–41 subsidies and transfers (2001–3) 338t sustainability, growth and integration with EU 332–44 track record 316–32 see also Balkan countries; CE-7; SEE-4 South-East Europe Free Trade Area (SEEFTA) 340 Southern Europe 202, 385 Soviet Union 21, 95, 275, 276, 294, 354, 355, 361(n6) Spain 6, 8, 15, 21, 38, 47, 81(n51), 87, 88, 158, 159, 161–2, 193, 199, 200, 202, 205, 223, 234, 250, 266, 282, 292, 385, 390, 392, 395 cohesion country 227–8 external position 224t, 227–8 FDI flows (1970–2000) 231, 231t FDI flows (before and after accession) 300t, 300 financial crisis (1992) 228 GDP per capita (Geary–Khamis dollars, 1950–2002) 238t, 239 GDP per capita (PPS terms, 1960–2000) 236–7, 237t, 237f GDP per capita (real growth rates, 1960–2000) 235, 236t integration effects (real GDP, 2001–10) of EU enlargement 201f losses from EU enlargement 211 macroeconomic effects of EU enlargement (2005–10) 208t trade with EU 2000 (percentage of GDP) 52f value added and labour force (1998) 53f see also cohesion countries; Mediterranean-3 specialization 170, 182(n8) spending ministries 33, 34, 35, 250, 251 stability 295, 305, 376 ‘stability culture’ (Portugal) 246, 251, 252

Stability and Growth Pact (SGP) 19–20, 38, 49, 78(n7), 168, 190, 205, 389 ‘excessive deficit procedure’ (EDP) 19, 46f, 46 ‘Stability Pact initiative’ 101(n14) Stabilization and Association Agreement (SAA) 187, 342 Stabilization and Association Process (SAP) 342 stabilization fund (suggested) 385 stabilization programmes 53, 54, 126, 138–9(n31) Standard and Poor 253 state 118, 309, 336 State Banking and Capital Markets Supervision Authority (Hungary, 1997–) 116 state control 271 state institutions 284 state ownership 106, 112, 134, 336 State Property Agency (Hungary) 109 State Property Management Corporation (Hungary) 109 steel 92, 93, 94, 95, 99 sterilizations 55, 78(n15) stock exchanges 111, 373 structural adjustment 38, 168, 170, 250, 301–2, 311(n15) front-loaded 44 pressures 171 Structural Funds 3, 5, 10–12, 156–9, 161–3, 180, 186, 199, 212(n3, n6, n8), 224t, 225, 232, 271, 301, 302, 307, 308, 311(n15), 371, 374, 385, 387, 388, 389–90, 391, 393 disbursement ratio (2000) 11 dual function 162–3 ‘Objective 1’ regions 163, 181–2(n7) ‘Objectives 1–4’ 153 solutions 159, 181(n5) success rate in acquiring transfers 153 structural policies (EU) 5, 7, 10 structural reform 178, 202, 251–2, 263(n9), 287, 303 deep structural transformation 60, 77 subsidies 158, 226, 336, 339 supply 189 Supreme Court (Hungary) 141(n52) surcharges 90, 97, 101(n12) Sweden 8, 22(n4), 87, 181–2(n7), 192, 203, 300t, 300, 395 switching autoregressive conditional heteroskedasticity (SWARCH) model 259, 260, 260t, 261–2, 264(n14) Markov switching process 259, 262

Subject Index 433 tablita 72 Tajikistan 349 tariffs 78(n14), 89, 90, 91f, 92, 97, 98, 100(n6, n9), 101(n12), 117, 190, 193, 226, 227, 300–1, 340 asymmetric reductions (EU-CEECs) 192 ‘asymmetry’ (shifting sides) 93–5 CEECs 193 internal 99 preferential 94 taxation 28, 44, 105, 226, 268, 271 administration 263(n9) evasion 233, 244(n12), 339 relief 5, 32, 232–3 technological gap 222 technological progress 79(n18), 284, 290 technology transfer 175, 181 telecommunications 223, 320, 340 telephone lines 280–1t, 282 terms of trade 90 textiles 87, 94, 330 ‘third way’ 375 tobacco 97, 340 total factor productivity (TFP) 5, 202 tourism 270, 320, 322, 335, 358, 341 TRACECA project 359 tradable sector 57, 60, 72, 76, 79(n18), 171, 176, 323 trade 29, 51, 52f, 53, 78(n12), 154, 163, 169, 191–2t, 222–3, 242, 243, 283, 307, 309, 340, 348, 359, 361(n3), 386 bottleneck 226, 232, 234 CIS, Baltic countries, CEE, EU (2001) 350t commodities 320 deficits 226–30, 243(n7) effects of EU enlargement 190, 191–2t, 192–3, 194, 200, 204 effects of EU enlargement on CIS countries 351–5 financing 234 intra-industry 170, 349, 361(n4) intra-USSR 354 Ireland 233, 244(n12) percentage of GDP (Greece) 268, 269f SEE 343 unregistered 269 Trade Agreement in Agricultural Products 101(n11)

trade agreements bilateral 98 discriminatory 90, 97, 100(n6), 100–1(n9) ‘spaghetti bowl’ (Bhagwati) 97 trade balance 221, 222, 223, 225, 228, 320, 326, 335 CIS–EU 349 deficits 221, 230 see also balance of payments trade balance multiplier 220 trade barriers 117, 296, 299, 340 trade creation 92, 193, 348, 353, 354–5, 359, 360 trade deficits 223, 229, 269–70, 271, 333, 349, 355, 381 trade deflection (direct and indirect) 98 trade diversion 92–3, 348, 349, 351–5, 359, 360, 379 trade intensity/intensification 52, 170, 196, 283 trade liberalization 88, 89, 100(n3–4), 101(n11), 119, 134 ‘not systematically associated with higher economic growth’ 243 trade openness 268, 269f trade policies 87–102 ‘asymmetry’ (shifting sides) 93–5, 100–1(n7–9) CEECs (emerging economic costs) 90–3, 100(n6) CEFTA conundrum 96–8, 101(n11–13) economic benefits 100(n4) Europe Agreements 89–95, 95–6, 97–8, 100(n5–6), 101(n10) European (early 1990s) 89–90, 100(n4–5) European (coming years) 98–100, 101(n14) political benefits 89, 95–6, 98 reasons for absence of clear trade doctrine among CEECs 88 trade theory, traditional 170 trade unions 250, 388 training 7, 156, 166 transaction costs 50, 154, 170, 283–4, 298, 301, 309 transfer pricing 232, 233 transfers (from EU budget to CEECs) 2, 3, 149–63, 190, 193t amounts 149–55 commitment appropriations 150 direct payments 154–5 enlarged EU after 2006 158–63 impact 155–8

434 Subject Index transfers (from EU budget to CEECs) – continued lump-sum 153 national cofinancing 153, 155, 157 payment appropriations 150, 153–4 political implications 155 preaccession transfers 151–2t, 153, 156, 181(n2) project-related transfers 153, 154, 181(n1–2) ‘transformational recession’ (Kornai) 175, 276, 286, 287, 311(n8), 318 deep (Hungary) 119 transition economies 38, 44, 50, 51, 53, 57, 73, 77(n5), 78(n7), 79(n19), 117, 126–9, 132, 134, 139(n38), 142(n72), 165, 168, 231, 243, 310(n4), 378, 384 merger control 142(n69) ‘transition with organized crime’ 339 transition process 28, 79(n20), 128, 141(n62), 205, 276, 283, 331, 333, 338, 342, 344, 344(n2), 365, 375 early phase 58 Hungary 131 reforms 356 role of budget process 30–2 transparency 108, 111, 188 transport/transportation 5, 78(n8), 154, 156, 174, 180, 283, 302, 320, 342 Treaty of Rome (1957) 373 Amsterdam amendment 119 ‘EC Treaty’: Article 124 203 paragraphs 85–6 119 Trends in International Migration (OECD) 361(n6) trust 139(n32) confidence-building measures 126 Turkey 99, 122, 185, 187, 306, 309, 315, 346, 393, 394 GDP per capita (Geary–Khamis dollars, 1950–2002) 238t, 239f, 240f GDP per capita (PPS terms, 1960–2000) 237t GDP per capita (real growth rates, 1960–2000) 236t, 244(n13) Maastricht convergence criteria 210t Turkmenistan 356 Ukraine 21, 173f, 201n, 287, 304, 305, 307, 309, 310, 346, 357, 369, 386, 392 see also CIS-4 ULCs see unit labour costs uncertainty 309, 311(n14), 342, 383 UNDP 279, 281n

unemployment 195, 198, 248, 250, 265–7, 288, 289, 311(n9), 319, 338–9, 388 disguised 319 structural 14, 379 unit labour costs (ULCs) 195, 226, 227, 228, 234, 326 United Kingdom 8, 87, 153, 193, 202, 263(n6), 390, 395 express exclusion from EMU 14 FDI flows (before and after accession) 299t, 300 ‘finance minister’ 389–90 integration effects (real GDP, 2001–10) of EU enlargement 201f macroeconomic effects of EU enlargement (2005–10) 208t ‘Objective 1 regions’ 181(n7) United Nations Economic Commission for Europe (UN ECE) 310(n1), 373 United States of America 21, 33, 79(n23), 87, 95, 99, 297, 299, 374 competition policy 137(n12) GDP per capita (Geary–Khamis dollars, 1950–2002) 238t, 239f, 240f GDP per capita (PPS terms, 1960–2000) 237t GDP per capita (real growth rates, 1960–2000) 236t merger control 120 regions 77–8(n6) state governments 31 universal banking 106, 116 Uruguay 80(n34) US dollar 80(n39), 249, 253, 260, 263(n7) dollarization 80(n45) Uzbekistan 357 value added 6, 52, 53f Versailles Treaty (1919) 310(n2) Vienna Institute for International Economic Studies (WIIW) 241n, 243(n1), 244(n12) forecasts 156, 181(n3) twenty-fifth Anniversary Conference (1998) xviii, 77(n1), 100(n1), 384, 395n visas 358, 359, 360 Visegrad countries 302 visions 370 volatility 247, 254, 255, 257–62, 263–4(n12–14) voluntary export restraints (VERs) 92

Subject Index 435 wage awards 60 drift 79(n22) flexibility 73, 76 formation 57–8, 79(n21–2) indexation 58, 60, 72, 76, 79(n22) rates 326 restrictions 235 structure 385 wage-setting 65 wages 3, 8, 53, 327f, 342, 191, 191t, 198, 234, 336, 337t flexible determination (Estonia) 76 high-wage countries 212(n3) low-wage countries 197, 212(n3) nominal 234 public sector (Portugal) 248 real 73 war 287, 318, 340 postconflict reconstruction 339 violent conflicts 338 Warsaw 140(n45) Washington 377 welfare state 295, 375 welfare systems 3, 9 wholesalers 124, 138(n25)

World Bank 38, 46f, 46, 243, 292 World Investment Reports (UNCTAD) 178 World Trade Organization (WTO) 54, 87, 88, 90, 96, 97, 99, 284, 297, 382 Code of Safeguards 94 dispute settlement mechanism 95–6 Doha Round 87, 389 key issues 92 negotiations 387 Uruguay Agreement on Safeguards 100(n7) see also GATT world wars 276, 380 ‘WorldScan’ 202 yen 79(n18), 253 Yugoslavia 21, 282, 286–7, 288, 304, 305, 311(n9), 312(n17), 315, 339, 341 currency tied to euro 306 disintegration 275, 303 see also CE-7 Zaire

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