Real Convergence in the New EU Member States

Paul Lassenius Kramp and Susanne Hougaard Thamsborg, Economics

INTRODUCTION AND SUMMARY

Since the dissolution of the Soviet Union in 1991, income per capita has shown considerable volatility in the new EU member states in Central and Eastern Europe. Following pronounced declines at the beginning of the period, these member states have, since 1997, generally seen higher growth rates than those observed in the old EU member states (EU-15)¹. This has brought income per capita closer to the level in EU-15, cf. Chart 1, i.e. there has been real convergence.

In the new EU member states, convergence towards the standard of living in EU-15 is typically accompanied by rising price levels. Hence, the new member states have experienced nominal convergence as well as real convergence. Nominal convergence is reflected in rising inflation and/or appreciation of the exchange rate.

This article reviews the process of real convergence and its economic-policy challenges. In addition, the impact of the chosen exchange-rate regime on the process of nominal convergence is described, including the member states' ability to meet the criteria for euro area membership set out in the EU Treaty, cf. the Appendix. The conclusion looks at the outlook for further real convergence. Focus is on the new non-euro area EU member states in Central and Eastern Europe, i.e. Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania and Slovakia.²

In the new EU member states, real convergence is to a high degree driven by productivity gains generated by increased capital inflows, structural reforms and institutional improvements. In general, the convergence process entails relatively large imbalances such as consider able current-account deficits and resultant rising external debt. The def icits have been financed primarily by inward FDI (foreign direct invest ment) and inflows of capital from foreign banks as a result of extensive financial integration.

The exchange-rate regimes of the new EU member states play an important role in economic development during the convergence pro cess. It is not clear which regime constitutes the best framework for com pliance with the Maastricht criteria. Member states with fixed-exchange-rate regimes tend to have stronger inflationary pressures and larger cur rent-account deficits, while member states with floating exchange rates tend to have larger government deficits.

The new EU member states are vulnerable to external shocks due to their large current-account deficits and thus strong reliance on external financing. Furthermore, in several of these member states a large share of the debt of the corporate sector and households is denominated in foreign currency, which impedes the central banks' efficient conduct of monetary policy.

A common feature of all the new member states is that they need to continue the course of structural improvement since there is still a consid erable income gap in relation to EU-15.

REAL CONVERGENCE

In this article, real convergence means that income per capita in the new EU member states is approaching the level in EU-15. Real convergence is driven by higher productivity growth than in EU-15. In the last 10 years, the new EU member states have reported productivity growth rates (GDP per employee) of 3-7 per cent year-on-year, compared with 0-3 per cent in EU-15.

Firstly, productivity is influenced by the quality of a country's institu tions, e.g. factors such as the degree of corruption, respect of private property rights and labour-market flexibility. In practice, the quality of the new member states' institutions is poorer than in EU-15. However, the mere wish for EU membership and to some extent the prerequisites for membership have accelerated the reform process and reduced the quality gap between institutions in the new EU member states and EU-15. This has boosted productivity and thus growth.

Secondly, the combination of institutional improvements, structural reform and the prospects of high returns has made investment in the new member states particularly attractive. This has led to strong expan sion of the capital stock as a result of both domestic savings and foreign investment. The transition to market-based economies with free capital flows has opened up for large inflows of capital and technology from the industrialised countries – especially Western Europe. The expansion of the capital stock has boosted productivity and thus economic growth.

CAPITAL FLOWS, FOREIGN DIRECT INVESTMENT AND FINANCIAL INTEGRATION

The real convergence process has given rise to expectations of large productivity gains and high returns. This has enabled the new EU mem ber states to attract considerable capital from the West. Prospects of higher income have also induced consumers and business enterprises in the new EU member states to increase consumption and investments. This has led to stronger demand for capital.

The consequences have been larger current-account deficits and accu mulation of substantial external debt. The current-account deficit has been predominantly financed by foreign direct investment, cf. Chart 2.

The new EU member states' ability to accumulate and finance of the substantial external debt can be explained primarily by the rapid and extensive integration of their financial markets with Western European markets. This is exemplified by the acquisition of large parts of the bank ing sector in Eastern Europe by Western banks, cf. Chart 3. The financial integration has provided easier access to euro liquidity, thereby reducing financing costs. Moreover, in member states with fixed-exchange-rate regimes, there is little risk associated with euro financing in so far as the exchange-rate regimes are supported by economic policy in general. Many loans have thus been granted as euro loans at low euro interest rates or even negative expected real interest rates.

This has entailed strong growth in credit to both the corporate sector and the households since 2000, cf. Chart 4.

For the household sector, housing debt has risen in particular, while housing prices have soared. In many countries, this has stimulated hous ing investments. For the corporate sector, construction investments and investments in the non-traded goods sector accounted for the strongest growth.

NOMINAL CONVERGENCE – APPRECIATION OF THE EXCHANGE RATE OR HIGHER INFLATION

As incomes grow in the new EU member states, consumer purchasing power approaches the level in EU-15. As a result, prices in the new mem ber states are being pulled towards the EU-15 level, measured in the same currency. This is an expression of nominal convergence.

Depending on the exchange-rate regime, nominal convergence is pri marily reflected in either rising inflation (fixed-exchange-rate regime) or appreciation of the nominal exchange rate (floating/flexible exchange-rate regime).

Wages and prices
Real convergence thus entails a risk of higher inflation compared with the level in the target countries, i.e. EU-15. The challenge is to keep the convergence process stable, while preventing inflation from soaring out of control, which could lead to overheating and subsequently strong growth in unemployment. From the end of the 1990s to just before the enlargement, most of the new EU member states experienced declining wage and price inflation, but since 2003 an upward trend has been observed – especially in the Baltic States, cf. Chart 5. The increase in wage inflation can be attributed to factors such as falling unemploy ment – from 11 per cent in the Baltic States, 15 per cent in Central Europe and 9 per cent in South-Eastern Europe in 2003 to 5, 9 and 7 per cent, respectively, in 2007 (unweighted averages).

The increased inflation observed in many of the new EU member states in recent years is partly of a cyclical nature. Accelerating domestic demand and GDP growth indicate overheating of several of the econ omies, as reflected in soaring prices, cf. Bini Smaghi (2007). Moreover, the most recent hikes in global oil and food prices are fuelling inflation to a greater extent in the new EU member states than in the euro area. This is due to the larger weights of the oil and food components in their overall consumer price indices.

Structural explanations can also be offered as to why inflationary pressures arise in converging member states. The Balassa-Samuelson ef fect is a well-known explanation for higher wage and price inflation in connection with real convergence. According to this effect, the conver gence process is driven by productivity gains. They are most pronounced in the traded goods sector, which is more exposed to competition than the service sector, i.e. non-traded goods, and can attract technology-intensive foreign direct investment. Wages in the traded goods sector tend to rise in step with productivity, which spills over into wage in creases in the non-traded goods sector despite the absence of productiv ity growth. Consequently, the increase in prices for non-traded goods exeeds productivity growth, thereby generating inflation. The Balassa-Samuelson hypothesis is only to a limited extent supported by empirical studies.³

Another structural explanation focuses on quality improvements as the cause of rising inflation in the converging member states. The theory is that the new EU member states not only manufacture and export higher volumes, they also manufacture and export better goods at higher unit prices. This entails ongoing quality improvement of the goods in the basket used in the consumer price index, causing prices to rise. Adjust ment for such quality improvements is difficult, so the measure tends to overestimate inflation, i.e. there is a "quality bias". The IMF has created a product quality proxy, Unit Value Ratio, cf. Igan et al. (2007). From around 2000, the Unit Value Ratio has risen considerably in most of the new EU member states, notably the Czech Republic, Estonia and Hun gary. This points to quality improvements that may entail "quality bias" in inflation data.

Exchange-rate regime and nominal convergence
Exchange-rate regimes play a pivotal role in the convergence process of the new EU member states. The Baltic States and Bulgaria have opted for narrow or no fluctuation bands against the euro, cf. Table 1. Hungary has also pursued a fixed-exchange-rate policy, but within a wider fluctuation band. These member states are named "fixed-exchange-rate regimes" in the following. Poland, the Czech Republic and Romania have opted for freely floating exchange rates governed by inflation targets. Despite ERM II participation, Slovakia in practice applies a managed float (within the fluctuation band) and has revalued its central rate in ERM II on two occa sions. These member states are named "flexible-exchange-rate regimes".

The choice of exchange-rate regime (fixed or floating) determines whether nominal convergence is reflected in higher inflation or nominal appreciation, cf. Chart 6.

In fixed-exchange-rate regimes, the central bank's task is to keep the exchange rate stable. Consequently, nominal convergence is almost en tirely reflected in inflation. This contributes to the current difficulties of especially these member states in meeting the inflation criterion, cf. the Appendix.⁴ On the other hand, the absence of monetary-policy means requires stricter fiscal discipline. All of the fixed-exchange-rate regimes except Hungary have modest government deficits or even surpluses.

A floating nominal exchange rate enables central banks to pursue in dependent monetary policy, which gives them greater scope to with stand inflationary pressures. Nominal convergence is therefore reflected in a combination of appreciation of the nominal exchange rate and in flation. However, the demands of fiscal discipline are less stringent, which has resulted in larger government deficits. Consequently, the flex ible-exchange-rate regimes are generally closer than the fixed-exchange-rate regimes to exceeding the convergence criterion concerning fiscal sustainability, cf. the Appendix.

Overall there is a tendency for the fixed-exchange-rate regimes to have larger current-account deficits, while the flexible-exchange-rate re gimes have larger government deficits, cf. Chart 7.

Fighting inflation – economic-policy means
The central banks of the fixed-exchange-rate regimes have to adjust monetary-policy interest rates in order to keep the exchange rate stable. This leaves no scope for independent monetary policy. Provided that the markets have confidence in the fixed-exchange-rate policy, the monet ary-policy interest rate will be close to the level in the anchor country (the euro area). This implies a tendency towards lower monetary-policy interest rates than otherwise warranted by the high growth rates in these member states. The consequences are pronounced credit growth, stronger domestic demand, higher GDP growth, intensified inflationary pressures and ultimately deterioration of the balance of payments.

The combination of strong growth dynamics and the lack of means to pursue independent monetary policy requires strict fiscal discipline in order to keep inflation at bay. Fiscal tightening measures work, but with a certain lag, and there are limits to the political acceptability of large budget surpluses. Furthermore, the convergence process itself requires public investments. There are, however, alternative means to curb infla tionary pressures, such as raising reserve requirements, reducing the maximum mortgaging ratios for homes and limiting interest deductibil ity (to dampen credit growth) and improving labour-market flexibility (to contain wage pressures).

In theory, flexible-exchange-rate regimes offer central banks more scope to counter mounting inflationary pressures. However, the more open the economy and the greater the share of loans denominated in foreign currency, the more limited is the scope for independent monet ary policy. This is because national interest rates and exchange rates play a less significant role.

It is characteristic of converging economies – whatever the exchange-rate regime – that globalisation tends to reinforce inflationary pressures. Declining activity, which ought to dampen inflationary pressures via ris ing unemployment, instead entails increased emigration. This can make it difficult to break an inflation spiral. The challenge is amplified even more by the recent surges in global oil and food prices – especially be cause the oil and food components generally have a larger weight in overall CPI than is the case in e.g. EU-15.

CONCLUSION – OUTLOOK FOR FURTHER REAL CONVERGENCE

The rapid and extensive integration of the new EU member states with EU-15 has entailed massive capital inflows due to expectations of high returns. This has paved the way for quick real convergence in many of these member states.

The rapid growth has been associated with large imbalances and signs of overheating, especially in member states with fixed-exchange-rate regimes, where the pace of the convergence process is generally faster than in the member states with flexible-exchange-rate regimes. To some extent, the substantial external imbalances can be regarded as a natural consequence of the convergence process. This applies particularly in member states where real convergence is based extensively on strong fundamental factors such as growth-promoting structural reforms, pro ductivity gains and considerable foreign direct investment (FDI).

In several of the member states, growth has exceeded the potential for the last couple of years, without being sufficiently underpinned by further structural reforms. To improve the balance of payments without any marked slowdown in consumption, competitiveness must be en hanced, e.g. by further boosting productivity growth. In many of the member states, the principal drivers of growth are private consumption and investment in the non-traded goods sector. These member states have not yet experienced the necessary (and expensive) shift of capital and labour towards the traded goods sector – where the best opportun ities for productivity gains can be found.

As a consequence of the strong financial integration, the current-account deficits and growth in consumption and investment have to a large extent been financed by external funds. External shocks, e.g. sudden shifts in exchange and interest rates and increased risk aversion among investors, pose a significant threat to the new EU member states – especially those with large current-account deficits. The risk of a hard landing for several of the new EU member states is therefore consider ably more pronounced in light of the financial turmoil over the past year, and growth is expected to decline in most of the new EU member states in the coming years, cf. IMF (2008).

Both fixed-exchange-rate and flexible-exchange-rate regimes can support the real convergence process as long as economic policy is con sistent overall. All the new EU member states should continue the re form process in order to create the best and most flexible framework as a bulwark against shocks and to ensure a more stable convergence pro cess. There is still a considerable income gap in relation to EU-15.

LITERATURE

Bems, Rudolfs and Philip Schellekens (2007), Finance and Convergence: What's Ahead For Emerging Europe?, IMF, Working Paper, no. 244, November.

Bie, Ulrik and Niels Peter Hahnemann (2000), Currency Boards, Danmarks Nationalbank, Monetary Review, 2nd Quarter.

Bini Smaghi, L. (2007), Real convergence in Central, Eastern and South-Eastern Europe, ECB conference, October.

ECB (2008), Convergence Report, May.

Égert, Balázs and Jirí Podpiera (2008), Structural Inflation and Real Exchange Rate Appreciation in Visegrad-4 Countries: Balassa-Samuelson or Something Else?, CEPR, Policy Insight, no. 20.

European Bank for Reconstruction and Development (2007), www.ebrd.com/ country/sector/econo/stats/index.htm.

Igan, Deniz, Stefania Fabrizio and Ashoka Mody (2007), The Dynamics of Product Quality and International Competitiveness, IMF, Working Paper, no. 97, April.

IMF (2007a), Regional Economic Outlook, Europe, November.

IMF (2007b), Annual Report on Exchange Arrangements and Exchange Restrictions.

IMF (2008), Regional Economic Outlook, Europe, April.

APPENDIX: CONVERGENCE CRITERIA

All EU member states aspiring to introduce the euro must meet the convergence criteria for euro area membership. There are four main cri teria:

1. Fiscal sustainability – the government deficit must not exceed 3 per cent of GDP, and the (gross) government debt must not exceed 60 per cent of GDP (or must be diminishing).
2. Price stability, defined as inflation of maximum 1.5 percentage points more than inflation in the three EU member states with the lowest inflation rates.
3. Persistent convergence in the form of limited spreads in long-term bond yields – long-term interest rates must not exceed the interest rates in the three EU member states with the lowest inflation rates by more than 2 percentage points.
4. Exchange-rate stability given by observance of the normal fluctuation band (+/- 15 per cent) in ERM II for at least two years without unilat eral devaluation.

Especially the Baltic States, Hungary, Bulgaria and Romania have dif ficulties in meeting the inflation criterion. All of these member states except Romania and Hungary pursue fixed-exchange-rate policies with narrow (or no) fluctuation bands against the euro. By May 2008, all the new EU member states except Hungary met the fiscal sustainability criterion.