The impact of EU membership on East European growth Laza Kekic, Economist Intelligence Unit Oxford,

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The impact of EU membership on East European
growth Laza Kekic, Economist Intelligence
UnitOxford, April 29th 2005
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Outline

• Overview of recent performance in Central Europe
  (new EU members) and the Balkans (future members)
• Growth and the EU factor
• expectations of rapid catch-up growth
• why they are frequently too bullish
• a historical perspective
• Estimating the impact of accession--long-term
  growth projections

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A comparative perspective, 2004
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Central European performance
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Recent Balkan progress

• In 2004 fifth consecutive year of respectable
  output growth
• Growth has outpaced growth in the central
  European new EU members in past four years
• Maintenance of macroeconomic stability and
  progress in fiscal consolidation
• Average Balkan inflation in 2004 lower than
  central European average
• Improving business environments
• Sharp upsurge in foreign direct investment (FDI)
  inflows

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Balkan growth performance
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Real GDP growth,
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Strong FDI flows to Balkans

• Strong surge in FDI to Balkans in 2003-04,
  despite poor global climate for FDI
• FDI slowdown in central Europe
• Narrowing of the gap between the Balkans
  countries and central Europe
• Sign of investor confidence discounting of
  political and other risks
• Harbinger of regional reallocation of FDI flows
  (despite EU enlargement)
• Key pointprivate flows, not official aid

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FDI inflows, USm
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FDI inflows by country (US m)
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Features of recent Balkan performance...

• Recent recovery led by private sectorFDI pick-up
  
• External official inputs contribute relatively
  little
• beyond, arguably, some basic conditions
• Striking that upsurge in foreign private sector
  investment based on only a few conditions
• -the restoration of peace and basic security
• -the beginnings of economic recovery
• -modest improvement in business environments
• Discounting of political risk

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but much remains to be done

• Politics
• Unresolved conflicts
• Policymaking errors
• Rule of law still weak
• General state weakness
• Demoralised and depressed populations
• Pockets of poverty and risk of social unrest
• Regulatory weaknesses

• Economy
• Weak exports growth
• Real GDP level still well below 1989 level
• High unemployment (despite grey economies)
• Correction of overvalued exchange rates
• Regional integration multilateral vs bilateral
  web

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Sustaining progress in Western Balkans

• A core EU agenda
• Fulfil security-related functions
• Keep open markets
• Credible membership perspective
• Some infrastructure assistance
• Movement of people and adjustments to Schengen

• Priorities
• Political stability
• Access to developed markets
• National sense of purpose and self-confidence
• Right balance in macroeconomic policies and
  structural reforms

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Key challenges for Central Europe

• Sustaining growth momentum in face of softness of
  West Europes economy
• Further institutional improvement
• no more EU reform anchor?
• The competitive threat from Asia and other
  eastern Europe
• Negotiate pitfalls on way to euro zone membership
• Cope with demographic decline

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The EU factor and catch-up growth

• Impact during pre-entry phase
• Impact after accession
• Many economic benefits due to EU market access
  rather than membership per se
• In Central Europe, unlike, under southern
  enlargement, most trade liberalisation and
  associated FDI effects prior to EU entry

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Impact of EU-prior to and after accession

• Positive
• Reinforces political stability
• Impact on trade and FDI
• Institutional development
• Encourages macro policy discipline
• Infrastructure development

• Some questions
• Stunts domestic politics
• Much of acquis inappropriate for less developed
• Diversion of scarce admin resources
• In weak states fosters damaging dependency
• Stability or growth bias

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EU membership and growth

• Impact on new EU members
• EU entry can offers a possibility, but by no
  means a guarantee of stimulating per-capita GDP
  convergence
• Inflated expectations and tendency to
  overestimate the impact on growth of EU accession
  factor
• Difficulty of isolating the effect of membership
  (and preparations for entry) on economic
  performance (problem of the counterfactual)
• Need growth model and long-term forecasts to try
  to answer the question

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Growth accounting

• GYaGL (1-a) GK TFPG
• GL growth in labour force (demography and labour
  force participation) possibly adjusted for
  skills
• GK growth in capital stock (based on assumed
  investment share and depreciation rates)
• TFPG total factor productivity growth
  (technological progress or dynamic
  efficiency), as a residual.

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Overestimating the impact

• Gross overestimates of the impact of EU accession
  on FDI flows
• Overestimate of the effect of aid flows on growth
  (little evidence of a significant link)
• Arbitrary assumptions about the EU effect on
  total factor productivity growth
• Any positive post-accession trends are ascribed
  to the accession as such
• Use of simple growth equations, arbitrary
  assumptions about investment rates, overestimates
  of the quality of human capital, insufficient
  allowance for the role of institutions

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Some false parallels 1

• One method is to draw lessons from previous
  enlargements - cohesion countries
• Usual conclusion poorly performing Greece an
  example to be avoided the miracle economy of
  Ireland the example to emulate.
• (Irelands income per head 61 of EU average in
  1973 128 in 2004)
• Experience of Portugal and Spain seen as
  generally positive, even if mixed in some
  respects
• but, a very imperfect basis to judge east
  European prospects

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Some false parallels 2

• The sample of countries from previous
  enlargements is very small
• Three key reasons why Irish experience cannot be
  replicated
• -Ireland has an English-speaking population
  and very close ties to the dynamic US
• -It had a favourable demographic structure
• -It had superior, well-developed institutions
  at the time of economic take-off
• EU has always advanced by lurching from crisis
  to crisis, but problems now may be of a
  different order

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Catch-up, GDP per head at PPP, EU15100
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A historical perspective
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Model for forecasting EU impact 1

• 19702000, 86 countries, growth in GDP pc
• Cross-section and decade panel estimations
• -Initial GDP per worker (US100)
• -Demography growth of working-age and growth of
  the total population
• -Human capital mean years of schooling and
  health of the workforce (life expectancy)
• -Policy variables openness to international
  trade government savings levels exchange rate
  overvaluation index (only cross section)
• -Index of quality of institutions rule of law,
  quality of bureaucracy, property rights

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Model for forecasting EU impact 2

• -A regulatory index covering the extent of the
  general government regulatory burden in product,
  credit and labour markets
• -ICT development index captures quantitative and
  qualitative features
• -External environment Changes in the terms of
  trade (only in panel)
• -Geography location primary products
  orientation
• -Historic legacies history of independent
  statehood

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East European growth prospects

• Fixed or slowly changing factors
• Scope for catch-up (, bar Slovenia)
• Geography ()
• Demographics (-)
• Institutions (-)
• Human capital (mixed)
• Policy-sensitive
• Regulation (mostly - at present)
• Openness ( in C Europe - in Balkans)
• Macro policies (mixed at present)

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Population growth, 2005-2025, pa
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EU membership and growth

• A benign scenario
• Further significant trade integration--result of
  the single market and eventual euro membership
• Further institutional improvement--best historic
  rates of improvement recorded by emerging markets
• Macroeconomic management that does not sacrifice
  growth to inflation-reduction and avoids
  exchange-rate overvaluation
• Fiscally neutral impact of accession (improved
  revenue collection offsets EU-related increases
  in current expenditures)
• Some deregulation in the EU as a whole, and
  further liberalisation in the new member
  countries

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EU membership and growth

• A malign scenario
• Mismanagement prior to euro entry, strong real
  appreciation pressures the euro overvalued
• Counter-inflationary policy is overzealous
• Fiscal reforms yield diminishing returns burden
  of accession-related expenditures
• Further institutional improvement is very slow
  (fewer incentives after membership)
• Slower progress in trade integration
• Little progress on EUs Lisbon Agenda
  ever-stronger pressure for EU harmonisation
  (growth-inhibiting parts of EU law, alignment of
  tax rates)

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Growth in GDP per head, pa, 2005-2025
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Slow catch-up - benign scenario
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Why will growth not be faster?

• Relatively modest quality of these countries'
  institutions, even under a trajectory of
  continued improvement
• Still deficient regulatory environment (aside
  from any future issues related to their
  implementation of the EU body of law)
• Unfavourable demographics (very low or negative
  projected rates of growth of the working-age
  population) and an unfavourable relationship
  between population growth and that of the
  working-age population

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Forward to the past GDP pc, EU15100
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Conclusions

• Even under benign assumptions, slow catch-up with
  developed Europe
• EU membership to add 1/2 percentage point to
  annual growth- benign scenario
• No narrowing of the gap between Balkans and
  Central Europe
• Present rate of recovery growth will slow (weight
  of poor demographics and institutions)
• Cannot replicate Irish/East Asian miracles
• But base case, if achieved, would still be a
  creditable performance in historical and
  comparative perspective

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