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

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

2. 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

3. A comparative perspective, 2004

4. Central European performance

5. 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

6. Balkan growth performance

7. Real GDP growth, %

8. 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 point—private flows, not official aid

9. FDI inflows, US$m

10. FDI inflows by country (US$ m)

11. Features of recent Balkan performance... • Recent recovery led by private sector–FDI 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

12. 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 …but much remains to be done

13. Priorities: Political stability Access to developed markets National sense of purpose and self-confidence Right balance in macroeconomic policies and structural reforms A core EU agenda: Fulfil security-related functions Keep open markets Credible membership perspective Some infrastructure assistance Movement of people and adjustments to Schengen Sustaining progress in Western Balkans

14. Key challenges for Central Europe • Sustaining growth momentum in face of softness of West Europe’s 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

15. 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

16. 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 Impact of EU-prior to and after accession

17. 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

18. Growth accounting • GY=a*GL + (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.

19. 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

20. 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. • (Ireland’s 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

21. 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

22. Catch-up, GDP per head at PPP, EU15=100

23. A historical perspective

24. Model for forecasting EU impact 1 • 1970—2000, 86 countries, growth in GDP pc • Cross-section and decade panel estimations • -Initial GDP per worker: (US=100) • -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

25. 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

26. 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)

27. Population growth, 2005-2025, %pa

28. 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

29. 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 EU’s Lisbon Agenda; ever-stronger pressure for EU harmonisation (growth-inhibiting parts of EU law, alignment of tax rates)

30. Growth in GDP per head, %pa, 2005-2025

31. Slow catch-up - benign scenario

32. 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

33. Forward to the past: GDP pc, EU15=100

34. 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