The impact of the EU's Structural and Cohesion Funds on real convergence in the EU Dr. Reiner Martin EU Countries Divisi

1. The impact of the EU's Structural and Cohesion Funds on real convergence in the EUDr. Reiner MartinEU Countries DivisionEuropean Central Bank Warsaw, 27 November 2003

2. Introduction • "The evidence examined in [the 2nd Cohesion Report] shows that over the previous programming periods (1989-93 and 1994-99) Community cohesion policies have had some notable success. This is perhaps most visible in the case of the regions where development is lagging behind, where there has been a general process of catching up in economic and social terms." (European Commission, 2001).

3. Introduction • “The best thing the EU could do for Greece is to cut off the structural funds immediately (…); anybody who works hard at a regular business is regarded as an idiot, since it’s much easier to set up a project to draw in European subsidies.” (The Economist 27 March 2003, quoting a ‘senior Greek official in Brussels’).

4. Overview • Introduction • The EU’s Structural and Cohesion Funds • Infrastructure and human capital as determinants for real convergence • Evaluations of the Structural and Cohesion Funds • Conclusions

5. The EU’s Structural and Cohesion Funds • Main aim is to improve long-term growth and employment prospects (supply-side approach) • No fiscal federalism • No sector-specific policy like the Common Agricultural Policy (CAP) • Less firm-level oriented than most national regional policies

6. The EU’s Structural and Cohesion Funds European regional policy objectives during the 2000-06 period • Relatively poor regions (Objective 1) • Regions with specific economic problems (Objective 2) • Education, training and employment outside Objective 1 regions (Objective 3) Cohesion Fund for relatively poor Member States

7. The EU’s Structural and Cohesion Funds Population covered by European regional policy objectives (in %)

8. The EU’s Structural and Cohesion Funds EU resources for structural action • From EUR 8 billion per year (1989) to 32 billion in 1999 (1999 prices) • From 20% of EU budget (1987) to above 35% (1999) • European Summit in Berlin (1999) resulted in slight decline of available resources for 2000-06 compared to 1994-99

9. The EU’s Structural and Cohesion Funds EU resources committed to structural action, 2000-06Breakdown according to Member State and objective*

10. The EU’s Structural and Cohesion Funds Functional distribution of EU Funds in Ireland, Greece, Portugal and Spain, 1994-99 (in %)*

11. The EU’s Structural and Cohesion Funds Financial resources for Acceding Countries • Until 2004 EUR 3 billion per year for all 12 AC and Candidate Countries (1999 prices) • Between May 2004 and end 2006 EUR 21.7 billion for 10 AC (1999 prices) • 2/3 of this will be Structural Funds, 1/3 Cohesion Fund • AC likely to be fully eligible for Objective 1 status (except Prague, Bratislava and Cyprus)

12. Determinants of real convergence Convergence theory • Free movement of goods and factors of production ensures that all regions achieve their technologically determined optimal level of capital intensity • Economic integration will lead to ‘automatic’ convergence • Conditional convergence theory: allows for regional/national differences in production technologies Divergence theory • Stresses differences in technology, transport costs and external effects • Policy action is required to bring about convergence Empirical evidence for last 20 years for the EU shows convergence at the national level but less so at the regional level

13. Determinants of real convergence Infrastructure and real convergence • Public infrastructure supports long-run growth by providing complementary inputs for private production • However, the net positive effect on production depends on whether it crowds in more private investment than it crowds out Why public infrastructure? • Public good case • Increasing-returns-to-scale/natural monopoly case

14. Determinants of real convergence Empirical evidence • Major methodological problems (e.g. accounting for quality differences, reverse causality) • There is reasonable evidence of positive effects of public investment on growth • Benefits of public investment are greatest in countries with a low level of infrastructure capital stock • Identification of key infrastructure bottlenecks is crucial in order to ensure an appropriate return on public infra-structure investments

15. Determinants of real convergence Human capital and real convergence • Endogenous growth theory gives considerable importance to human capital as explanatory factor for growth • Idea that human capital also increases the capacity to innovate and to adapt new technologies Why public investment? • Social returns to individuals’ investments in education might outweigh private returns • Case for publicly subsidised education is reinforced if credit markets are imperfect

16. Determinants of real convergence Empirical evidence • Methodological problems (proxies for human capital, reverse causality) • Some evidence that education is beneficial for growth but weaker than theory would suggest • Diminishing returns on education, primary education being the one with the highest return • On-the-job training and adult education could be also beneficial but the available evidence is rather limited

17. Evaluations of the EU Funds Types of evaluations • Evaluations for specific projects or programmes • Analyses based on aggregate public investment or EU transfers as explanatory variable • Macroeconomic models Some common problems • Lack of sufficiently long and detailed regional time series for many variables • Funds have operated for relatively short period (particularly problematic for the identification of supply-side effects)

18. Evaluations of the EU Funds Evaluations for specific projects or programmes • Quality of the evaluations varies considerably • Somewhat less interesting from a macroeconomic perspective • Indispensable for making the right choices in designing concrete projects and programmes • Venables and Gasiorek (1999) use models based on economic geography to investigate inter-regional spill-over effects of major CF funded infrastructure investments • Location of such projects crucial for extra-regional effects

19. Evaluations of the EU Funds Econometric tests using cross-section or panel-data analyses • This strand of evaluations suffers in particular from data constraints • On balance rather pessimistic although there is some heterogeneity in the results • Recurrent issue is the impact of the quality of national institutions in the recipient countries on the effectiveness of the Funds

20. Evaluations of the EU Funds Macroeconomic models • Results differ considerably, depending on the model specifications and the ways in which the models take the impact of the Funds into account HERMIN • HERMIN introduces the effect of the Funds in two ways: 1. Standard expenditure and income shocks 2. Policy externalities (Increased TFP, increased attractiveness for FDI, enhanced ability of endogenous industries to compete abroad) • Simulation assumes funding to terminate after 2006 • Supply-side effects of 1-2% GDP growth per year for Cohesion Countries and Eastern Germany

21. Evaluations of the EU Funds HERMIN simulation results on the impact of Objective 1 CSFs 2000-06 on the level of real GDP in the Cohesion Countries and Eastern Germany (in % deviation from baseline)

22. Evaluations of the EU Funds QUEST II • QUEST II model is forward-looking, with behavioural equations based on the intertemporal optimisation of households and firms • Real interest and exchange rates are determined endogenously, so that possible crowding-out effects can be taken into account • Impact of Funds is modelled as increase in the public capital stock, which impacts on a neo-classical production function • For 2000-06 the results of QUEST II simulations for the Cohesion Countries are low compared to HERMIN • HERMIN and QUEST II estimates for supply-side effects are more similar

23. Evaluations of the EU Funds QUEST II simulation results on the impact of Objective 1 CSFs 2000-06 on the level of real GDP in the Cohesion Countries (in % deviation from baseline)

24. Conclusions • Short-term redistribution and demand effects of the Funds more easily identifiable and relatively undisputed • Considerable uncertainty about the long-term supply-side effects • ‘Smallest common denominator’ • Well designed measures to upgrade infrastructure and to increase human capital are likely to have a positive impact on growth • In particular in regions where infrastructure and human capital are likely to represent growth bottlenecks • On balance the results suggest that EU regional policy can have a positive long-term impact on economic growth in the recipient countries and regions

25. Conclusions Improvements to the current system of regional support • Further strengthen the focus on physical and human capital building • Improvements of Member States’ administrative capacity could become a new priority for the Funds • Further simplifications of the procedures • Improved co-ordination between EU regional policy, national regional policy and non-spatial European and national policies • Further spatial concentration of support • Enlargement shifts main dimension of income differences from regions to countries • Allocation of funding may thus need to become more strongly based on national socio-economic characteristics

26. Conclusions More far-reaching lessons • Funds can only exert a positive impact on real convergence if the supported countries are characterised by a stable macro-economic environment and institutional and microeconomic structures that are conducive to growth • Low level of inflation and sound budgetary policies • Regulatory framework that facilitates the setting-up and growth of endogenous companies as well as FDI, a business-friendly tax system, sound financial markets • Look more closely at the link between factor returns and productivity in order to ensure for example that wage-setting systems take local productivity differences sufficiently into account

27. Thank you for your attention!