EU Enlargement: Managing The Transition

In an earlier article we identified some of the key policy issues that are likely to emerge as the EU enlargement process moves forward and culminates in the transformation of the EU-15 into the EU-25, perhaps as early as 2004.[1] In this article we look at some of the key factors that are likely to shape the macroeconomic environment for the accession countries and the constraints these are likely to pose for policymakers. The policy responses they elicit will largely determine how quickly the new members feel comfortable within the enlarged EU and how well they are able to withstand the increased competitive pressures. Three closely interrelated issues are likely to play a prominent role: growth, capital inflows, and relative price adjustments.

EU accession candidates are expected to continue to grow fast in the next several years. The medium-term growth potential of the eight transition economies in central and eastern Europe in particular (the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia) remains high, reflecting the continued elimination of the distortions of the central planning era and the beneficial effects of the institutional and policy improvements required for EU entry. The implementation of so-called “second generation” structural reforms (eg, to pension systems and financial sectors) are also likely to play a role, as will the fact that these countries have well-educated labour forces, which should boost labour productivity.

Good fundamentals mean that capital will continue to flow into transition economies and, broadly speaking, the more well-managed the economy, the greater these inflows are likely to be. They will take the form of FDI and portfolio flows but, with good growth prospects, the private sectors could be expected to borrow abroad as well, boosting current account deficits. A counterpart of capital inflows is high growth rates for imports, partly reflecting the import requirements of newly established firms and foreign affiliates, but also the modernisation needs of existing enterprises, which, to stay competitive, must invest and upgrade. Indeed, these processes are already underway and large current account deficits have been a permanent feature of the macroeconomic landscape in virtually all of these countries.

Relative price adjustments in the transition to a market economy are among the key factors that have contributed to the persistence of higher inflation in transition countries. The prices of previously heavily-subsidised goods and services (eg, food, housing, healthcare, public utilities) with a large weight in the CPI have all increased sharply, and such increases have not been offset by decreases in the prices of other goods, leading to upward adjustments in the price level. While this gap has narrowed, it is still there and will continue to put pressures on the currencies for real appreciation. Prices of non-tradeables are rising faster (than the overall CPI) nearly everywhere among transition EU candidates, and this means that these economies will continue to experience real appreciation, beyond the 20-60% seen over the past five years.

The above factors are likely to reinforce each other. Countries expected to grow more rapidly and to experience real appreciations may attract even more capital inflows. Increased productivity in the tradeables sector and rising relative prices in non-tradeables will increase the return on capital in both sectors and boost capital inflows. This, in turn, could put pressures on currencies for real appreciation, higher current account deficits and foreign debt accumulation by the private sectors. The question which policymakers will want to ask is whether the above set of factors imply any particular risks in the run-up to EU entry.

One possible scenario to this policy environment sees the authorities managing the pressures identified above through a combination of cautious fiscal policies and structural reforms. Tight budgets mitigate the pressures on the current account, while structural reforms enhance productivity and increase the level of the equilibrium exchange rate that is consistent with export competitiveness. In this scenario, some of these countries might want to continue to keep credit lines with the IMF open, as a confidence-building mechanism, and might adapt their exchange rate regimes to changing circumstances, such as the broadening of the fluctuation bands carried out in Hungary last year. This scenario assumes that there would be no major external shocks that might lead to capital outflows and put undue pressures on the exchange rate (particularly in those countries with fairly tight pegs), leading to possible currency crises. The main constraint in this scenario would be the need for budgetary restraint, at a time when it might make more sense for governments to have a more active fiscal policy, for instance to increase capital spending for infrastructure or to upgrade the countries' health and education systems ahead of EU entry. Some countries, such as Poland and the Czech Republic, might find this quite a tall order, given the large public sector deficits which are presently envisaged, of as much as 7-9% of GDP in 2003.

An implication of the above is that countries will have to figure out how to satisfy the Maastricht inflation criteria ahead of EU entry (with inflation rates not to exceed the average of the three best performers in EMU plus 1.5%). With their hard pegs, nominal appreciation of the currency is not an option open to four of the 10 countries - five if one includes Bulgaria is included, a country confronting the same issues. So, fairly tight budgets may be the only way out. This has led some to question the appropriateness of the Maastricht inflation criterion for new applicants, as it would impose slower growth than would otherwise occur ahead of EMU entry and/or an overvalued exchange rate upon entry. Given that the accession countries do not have an opt-out from EMU and have all thus agreed to adopt the euro in due course, this scenario assumes that the authorities would be prepared to deal with the above stresses for a minimum of 3-5 years starting 1 January 2002.

Whose countries unable to implement a tight fiscal policy will obviously be more vulnerable and may see their full participation in EMU delayed. For those able to rise to the above challenges, however, the benefits are likely to be substantial. The main benefit of EMU will stem from the elimination of “currency risk”, together with the capital outflows and volatility that often accompany it. Interest rates would be expected to decline and would perhaps be higher than international (euro-area) rates only in reflection of country risk. Lower interest rates would in turn bring about budgetary savings, as governments issued bonds at lower rates. To this could be added the savings associated with monetary operations which central banks carry out to sterilize capital inflows.

The adoption of the euro would surely strengthen financial links with the euro area and the global economy. Greater price stability would dispel uncertainties and would improve investor sentiment as countries’ commitment to financial stability and sound fiscal policies were perceived to be irreversible. The elimination of currency risk would also reduce the collateral effects of contagion episodes, which can be quite ugly in their ramifications. Furthermore, the risk of a currency crisis precipitating a banking crisis because of currency mismatches would be greatly diminished as well. Closer integration with financial markets would encourage capital inflows and boost growth prospects, without the undesirable effects identified above, either in terms of an appreciating currency or the need to have budget surpluses to mitigate the effects of growth and capital inflows on the current account. So policymakers would be able to focus on structural reforms without immediately having to put the brakes on the economy because of concerns about “external sustainability.”

[1] See “European Union Enlargement Issues”, Global Weekly Economic Monitor, 1 March 2002.