Macroeconomic and Fiscal Challenges Facing Central European Countries during the EU Accession Process. No.26. M a r e k D ¹ b r o w s k i - PDF

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M a r e k D ¹ b r o w s k i Macroeconomic and Fiscal Challenges Facing Central European Countries during the EU Accession Process W a r s a w, No.26 The views and opinions expressed in this publication

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M a r e k D ¹ b r o w s k i Macroeconomic and Fiscal Challenges Facing Central European Countries during the EU Accession Process W a r s a w, No.26 The views and opinions expressed in this publication reflect Author s point of view and not necessarily those of CASE. This paper was prepared for the research project No. P R (ACE PHARE Programme 1996) on The Medium and Long-term Perspectives of Fiscal Adjustment of Selected Central European Countries . CASE gratefully acknowledges financial support from ING Barings, that made this publication possible. DTP: CeDeWu Centrum Doradztwa i Wydawnictw Multi-Press Sp. z o.o. Graphic Design Agnieszka Natalia Bury CASE Center for Social and Economic Research, Warsaw 1999 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, without prior permission in writing from the author and the CASE Foundation. ISSN ISBN X Publisher: CASE Center for Social and Economic Research ul. Sienkiewicza 12, Warsaw, Poland tel.: (48 22) , fax (48 22) Marek D¹browski Professor of Economics V-Chairman and one of the founders of the CASE Center for Social and Economic Research in Warsaw From 1991 involved in policy advising for governments and central banks of Russia, Ukraine, Kyrgyzstan, Kazakhstan, Georgia, Uzbekistan, Mongolia, and Romania; First Deputy Minister of Finance of Poland; Member of the Sejm (lower house of the Polish Parliament); Chairman of the Council of Ownership Changes, the advisory body to the Prime Minister of Poland; visiting consultant of the World Bank, Policy Research Department; from 1998 Member of the Monetary Policy Council of the National Bank of Poland. Recently his area of research interest is concentrated on macroeconomic policy problems and political economy of transition. Abstract At the end of 1997 five transition countries the Czech Republic, Estonia, Hungary, Poland, and Slovenia were invited to start negotiations on their accession to the EU. Three other countries Latvia, Lithuania, and Slovakia may still join the first group. Two other countries Bulgaria and Romania have concluded free trade and association treaties with the EU and have less clear accession perspectives, as their transition performance has lagged behind the frontrunners. The purpose of this paper is to present an overview of the main macroeconomic and fiscal challenges that may appear during the accession process, and indeed post-accession. Attention will be concentrated on fiscal problems, since fiscal performance plays a crucial role in determining of macroeconomic balances. At the same time, it also often reflects the progress achieved in structural and institutional reforms. The paper summarizes the results of the comparative ACE- PHARE research project on Medium and Long-Term Perspectives of Fiscal Adjustment of Selected Central European Countries (P R), which covered four Central European countries: the Czech Republic, Hungary, Poland, and Romania. Contents ABSTRACT Introduction Is catching-up to EU national income levels likely? Balance of payments problems Disinflation, monetary and exchange rate policies Fiscal outlook at the beginning of the accession process Fiscal imbalances and public debt High level of fiscal redistribution Hidden fiscal liabilities Medium and long-term fiscal sustainability Long term sustainability test Revenue and expenditure projection Fiscal challenges connected with the accession process Review of some crucial expenditures and revenues items Public pension programs Health care Agriculture sector Indirect taxation Direct taxation Concluding remarks References Tables and graphs Marek D¹browski 1. Introduction At the end of 1997 five transition countries the Czech Republic, Estonia, Hungary, Poland, and Slovenia were invited to start negotiations on their accession to the EU. Three other countries Latvia, Lithuania, and Slovakia may still join the first group. Two other countries Bulgaria and Romania have concluded free trade and association treaties with the EU and have less clear accession perspectives, as their transition performance has lagged behind the frontrunners. Until now (i.e. spring of 1999) accession negotiations have concentrated on various institutional, legal, and microeconomic issues. The macroeconomic problems of candidate countries have not been discussed extensively as yet, and it is not clear what kind of macroeconomic criteria will be finally applied as conditions of membership. Most researchers and analysts while discussing the macroeconomic perspectives of candidate countries traditionally refer to the five criteria set by the Maastricht Treaty. However, these were formally binding only on the first group of the EMU candidates and will not be automatically applied to the new EU members [see Kosterna, 1998, p. 10]. Moreover, as we shall see below, these criteria are not necessarily always relevant to the specificities of the macroeconomic situation of candidate countries. The above does not mean that the candidate countries will not face serious macroeconomic and fiscal challenges or that these problems will not complicate the accession process. At the moment, this issue is overshadowed by the negotiations relating to the legal harmonization process and the restructuring of certain sensitive sectors. Assessing the macroeconomic situation of candidate countries using the Maastricht criteria gives the erroneous impression that they are already close to fulfilling the requirements of EMU membership, and will not experience serious problems with macroeconomic convergence. In addition, too frequent acknowledgement of the leading position of some countries in the transition process (particularly of Hungary or Poland) does not also help them face the scale and nature of possible difficulties. The purpose of this paper is to present an overview of the main macroeconomic and fiscal challenges that may appear during the accession process, and indeed post-accession. Attention will be concentrated on fiscal problems, since fiscal performance plays a crucial role in determining of macroeconomic balances. At the same time, it also often reflects the progress achieved in structural and institutional reforms. To this end, the paper will summarize the results of the comparative ACE-PHARE research project on Medium and Long-Term Perspectives of Fiscal Adjustment of Selected Central European Countries (P R), which covered four Central European countries: the Czech Republic, Hungary, Poland, and Romania [1]. The first three are already involved in accession negotiations and are widely considered as leaders of the post-communist transition process, while Romania has still to complete the first stage of transition, and its EU accession perspectives are as yet unclear. Our analysis will start from the differences in GDP per capita between the CEECs and EU member countries, relative growth performance, and growth prospects (section 2). Then we will turn to problems of financing growth, i.e. the savings-investment gap, capital inflows, and current account deficits (section 3). This will be followed by an analysis of monetary and exchange rate policies and inflation performance (section 4). Fiscal policy may play an important role in supporting the disinflation process, mitigating excessive current account deficits, and creating favorable conditions for economic growth. At first glance, the current fiscal situation of the countries analyzed does not look bad (though it is differentiated), but there are a number of problems that are not reflected in the standard cash-basis fiscal statistics. Examples are the implicit pension debt or contingent liabilities in the banking system (section 5). Moreover, the medium and long-term fiscal perspectives of the countries analyzed depend strongly on the expected rate of GDP growth, and under a low growth scenario, they are very bad indeed. The accession process itself will also influence both the expenditure and revenue sides of the applicants' budgets. This means that a further fiscal adjustment may be needed in order to meet these challenges (section 6). Such an approach leads us to a more detailed analysis of some aspects of both revenue and expenditure policies, and also of institutional reforms which determine the expenditure side of the budget (section 7). Finally, we will try to specify possible strategies for dealing with the problems identified (section 8). [1] The summary nature of this paper means that I will extensively draw from a number of other papers prepared under the same research project by its participants: Stanislaw Gomulka, Urszula Kosterna, Georges de Menil, Peter Mihalyi, Jacek Rostowski, and Pavel Stepanek (project partners), and Max Gillman, Michal Gorzelak, Piotr Jaworski, Wojciech Maliszewski, Jaroslaw Neneman, Ryszard Petru, Ondrej Schneider, Joanna Siwinska, Marek Styczeñ, Magdalena Tomczynska, Zoltan Vajda, Mateusz Walewski, and Katarzyna Zawalinska (research assistants). The mentioned papers relate either to problems of specific country or analyze certain problems from the cross-country comparative perspective. The contribution of individual authors will be noted and acknowledged. In addition, Atilla Hajos and Monica Iosif helped us to collect data on Hungary and Romania. Miroslaw Gronicki provided the econometric consultation. Stanislaw Gomulka and Jacek Rostowski helped author with final version of this paper. However, author accepts sole responsibility for the content and quality of this paper. 8 Macroeconomic and Fiscal Challenges Facing Central European Is catching-up to EU national income levels likely? Former communist countries lost at least a half-century of normal economic development. The nature of their growth built serious structural distortions into their economies, which made them highly inefficient, compared to the rest of the world. This led to an unavoidable output decline after the collapse of communism [see Gomulka, 1998]. According to the simulation of Fischer, Sahay, and Vegh (1998a), GDP per capita in the six Central and East European countries, i.e., Bulgaria, former Czechoslovakia, Hungary, Poland, Romania, and former Yugoslavia, would have been at least three times higher on average by 1992, if they had continued the capitalist way of development after WWII. Making up for this lost time will take at least 15 years in the case of the Czech Republic, 20 years in the case of Hungary and Poland, and 30 years in the case of Romania. Table 1 illustrates the 1995 per capita GDP level of the candidate countries calculated in PPP terms and compares it with the average GDP per capita level of three lowest income countries in the EU, i.e. Greece, Portugal, and Spain. The gap ranges from 74% of the average EU level in the case of Lithuania to 30.1% in the case of the Czech Republic. After a few years of output decline, the countries, which were more advanced in the transition process returned to economic growth, when first set of necessary market reforms began to bear fruit. However, the rate of growth has been uneven, as is demonstrated in Table 2. So far, Poland has presented the best cumulative growth record. However, one must take into consideration that Poland was the first country to start comprehensive economic reforms (at the end of 1989) and the first to overcome the output decline (in 1992). Among countries which began transition somewhat later Slovakia, Slovenia, and the three Baltic countries can also be classified as fast growing countries. Hungary, starting its transition very early, was surprisingly a slow growing country until 1996, partly as a result of the macroeconomic crisis. The Czech Republic, another reform leader recorded only one year of fast growth (1995), while has brought a return of output decline. Again, the macroeconomic crisis of 1997 seems to be at least a partial explanation for this phenomenon. Romania started its economic growth relatively early (1993), in spite of very limited progress in macroeconomic stabilization and microeconomic restructuring at that time. This premature recovery led to a macroeconomic crisis in , which turned into a serious recession in The same happened with the Bulgarian growth experience of , which ended with one of the most severe financial crises in the whole transition and a deep output decline in Due to a very tough reform program, Bulgaria seems to have returned to economic growth, as is reflected by its 1998 results. Explaining the transformation recession and the subsequent recovery and growth, as well as their differentiation across countries is no easy task [see Gomulka, 1998]. Relatively short time series, of not necessarily good quality, and inherent difficulties in measuring various qualitative factors influencing growth behavior, make any econometric analysis quite risky. However, most attempts [2] have come to the following conclusions: 1. The size and length of the initial transformation output decline [3] was determined both by the size of accumulated macro- and microeconomic distortions, and by the transition policy pursued by governments. 2. During the recovery, the conventional determinants, i.e. investment, labor, and human capital accumulation, played only a limited role. The reallocation of existing resources as result of elimination of previous distortions (e.g. price and trade liberalization) seems to have been much more important. Thus, uncharacteristically of other depressions, macroeconomic stabilization, and progress in structural and institutional reforms usually emerge as the most important factors determining growth performance. 3. External trade shocks and political shocks also seriously influenced growth, at least in the short run. Among many such impulses, one can mention the succession of Balkan conflicts or the financial crisis in Russia and other CIS countries in 1998 (which affected Poland and the Baltics in ). 4. Once the initial recovery is completed, further growth will probably be determined, to a greater extent than before, by conventional determinants, i.e. investment, labor, and human capital. This last conclusion brings us to the problem of the growth prospects of the candidate countries. There is a widespread expectation that these economies will grow faster than the current EU members, gradually closing the development gap. The first obvious argument supporting such an expectation is based on the well know convergence hypothesis: countries with lower initial GDP per capita usually grow faster, other things being equal, than countries with higher GDP per capita level [see Barro and Sala-I-Martin, 1992; Sachs and Warner, 1996]. Rostowski (1999) gives a number of additional arguments connected with the expected continuation of eco [2] Among the latest ones see e.g. De Melo, Denizer, Gelb and Tenev (1997), Fischer, Sahay and Vegh (1998b), Havrylyshyn, Izvorski, and van Rooden (1998), IMF (1998a). All these exercises base on the theoretical foundation of the contemporary endogenous growth theory. [3] It should be noted that the size of this decline has been usually overestimated for many methodological reasons. Overestimation of the initial GDP level, underestimation of the unofficial sector rapidly expanding during transition, difficulties with estimating quality changes are the most frequent statistical problems observed in individual countries. 9 Marek D¹browski nomic reforms. EU candidate countries will probably be fast growing for the following reasons: 1. They have stopped pursuing the very bad economic policies, which they had in the past under central planning (pervasive government control, extensive subsidies, massive foreign trade distortions, etc.). 2. The existence of considerable gains from learning by doing within the institutional infrastructure of the market economy, which was initially non-existent (e.g. the bankruptcy courts, customs services, and financial institutions), which can be expected to continue for some time to come. 3. New structural reforms which are coming on stream (e.g. pensions' reform, privatization of utilities). 4. Expected benefits of EU and EMU membership. In the light of the earlier discussion of the sources of early post-transition recovery, one needs to ask to what extent these potential sources of growth have already been used up (particularly the first two factors). Visual inspection of Table 2 does confirm the feasibility of the fast growth hypothesis (at a rate of at least 4 5%) though there is no guarantee that such a high rate will be sustained through the whole of the next decade. Among the first group of candidates, the Czech Republic seems the most problematic. Among the remaining five countries, Romania appears to be in the most dramatic situation. Using 1995 GDP per capita PPP based data, Fischer, Sahay and Vegh (1998a) tried to forecast the future average rates of growth of the CEE countries basing on Barro (1991) and Levine and Renelt (1992) growth equations. They also estimated the number of years needed by each country for convergence to the average level of per capita GDP of the three lowest income EU countries (Spain, Portugal and Greece), assuming that the latter will grow at an average annual rate of 2%. Results are presented in Table 3. Two important conclusions can be drawn from this simulation. First, growth rates in the range of 5 7% seem to be a realistic forecast [4]. Thus, the fast growth hypothesis may be taken as a reasonable assumption for projecting other macroeconomic and fiscal variables. However, such an optimistic scenario strongly depends on further progress in economic reforms and sound economic policy. Second, even the fast growth scenario does not give prospects of fast convergence, even to the lowest-income EU countries. In the best case (that of the Czech Republic), according to Barro equation catch-up will take 11 years, in the worst cases (Lithuania, Romania) more than 30 years. Such a long lasting convergence may create many economic, social, and political problems, which may themselves complicate the accession process. Growth prospects have important implications for other macroeconomic variables and policies. The fast growth hypothesis implies, for example, strong pressure for real appreciation and expanding current account deficits on the one hand (see next section), but on the other it also gives much more room for maneuver in the fiscal policy sphere (see section 6). A slow growth scenario makes balance of payments problems less acute, but seriously challenges the sustainability of the long-term fiscal position of candidate countries. 3. Balance of payments problems A fast growth scenario in the candidate countries (far faster than the UE itself) will lead to continuous real appreciation of national currencies and widening current account deficits. These phenomena can be explained from at least three theoretical points of view: 1. The investment-saving imbalance (balance of payments identity). 2. Consumption smoothing models. 3. Real appreciation coming from the Harrod-Balassa- Samuelson (H-B-S) effect. Focussing on the investment-saving imbalance, a high growth scenario may require an increasing investment to GDP ratio as non-investment sources of growth (improving X-efficiency and the efficiency of factor allocation) have been substantially exploited in the first stage of the posttransition recovery in a number of countries. Table 4 presents the investment and saving data for eight candidate countries: Bulgaria, the Czech Republic, Estonia, Hungary, Poland, Romania, Slovakia, and Slovenia. Both indicators are highly differentiated across the countries, which may partly reflect measurement problems. However, some interesting observations can be drawn from this table as well as from Table 5, which records current account balances of the ten candidate countries. Apart from Bulgaria and Slo
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