Economic momentum in selected accession countries
The following article takes a closer look at the progress achieved with convergence over the last few years in selected accession countries. All in all, the region coped relatively well with last year’s international slowdown in growth. Growth declined from just under 4% in 2000 to 2.2% in 2001 in Poland, Hungary, the Czech Republic and Slovakia. But this low rate of expansion is mainly attributable to poor economic momentum in Poland. After all, Poland is the region’s largest economy. Adjusted for the development there, Hungary, the Czech Republic and Slovakia achieved solid growth of 3.6% in 2001 (similar to 2000) and markedly exceeded the pace in the EU member states. This trends looks set to continue in the current year: we expect no recovery in Poland, while the economies of Hungary, the Czech Republic and Slovakia will likely grow at 3.5- 4%. In terms of per capita income, however, the accession countries will not catch up with the EU soon as their growth lead amounts to only one to two percentage points. For per capita income to reach EU levels, the applicant countries would have to experience a growth dynamic seen only in the Baltic states last year: economic expansion there came to more than 6%. But Estonia, Latvia and Lithuania, too, will likely see the pace of growth decelerate this year.
Poland: setback to convergence process caused by economic crisis
Poland had long been considered a model candidate among the transformation countries but slipped into economic crisis in 2001. This is reflected in the DB Research convergence indicator, which also monitors economic indicators such as GDP growth, unemployment and budget deficits: for 2001 it shows a decline and will probably even slip below the 2000 level this year.
GDP growth in Poland fell from more than 4% in 2000 to 1.1% in 2001 and will likely come to only about 1% this year. Owing to the economic downturn unemployment rose above 18% in spring 2002. A further increase to more than 20% in 2003 cannot be ruled out. The slowdown in growth is the result, first and foremost, of the restrictive monetary policy pursued by the central bank in order to prevent an overheating of the economy. This also counteracted the relatively expansionary fiscal policy. The continued policy of high interest rates – despite gradual rate cuts real interest rates remain very high – is having a negative effect on domestic demand, however, and is making economic recovery more difficult.
The central bank’s restrictive monetary policy has pushed inflation down markedly. In June, the inflation rate dropped to 1.6% yoy. Even though the central bank is currently bringing down interest rates, inflation will almost certainly fall below the 4-6% target range by the end of 2002. We expect the rate to come to 3% at year-end. This is already in line with the central bank’s medium-term target.
Low growth and high unemployment have led to massive political pressure on the monetary authority. Parliament, in particular, is critical of the central bank. This spring, the members of parliament voted on and condemned its high interest-rate policy. The former Finance Minister Belka has called upon the central bank to intervene in the forex market in order to weaken the zloty. At present there are talks between the government and the central bank about possible modifications to the exchange-rate regime. A transition from a flexible zloty to a managed float might enable the government to weaken the currency without directly interfering with the central bank’s independence. This would be the case, for example, if the exchange-rate regime were to impose an upper limit close to the current exchange rate. This would force the central bank to cut interest rates or intervene in the forex market as soon as the zloty came dangerously close to its ceiling. In addition, parliament is cu rrently debating changes to the central bank statutes. The measures that are being discussed would allow the government to undermine the central bank’s independence: for one thing, growth and employment are to become central bank targets (besides price stability); for another, the monetary policy council is to be expanded. The central bank rightly fears that the government will seek to influence monetary policy decisions. This domestic pressure is countered by international organisations such as the EU, the IMF and the ECB, which are highly critical of government influence over Poland’s independent central bank. However, much of the markets’ nervousness seems exaggerated as Poland’s president, Aleksander Kwasniewski, would likely veto a bill that aims to reduce the central bank’s independence.
Owing to poor growth, the budget situation has deteriorated dramatically in Poland. The budget deficit stood at 2.7% of GDP in 2000 but will probably swell to 6.3% of GDP this year. Even with growth in the order of about 3% in 2003, the deficit will still amount to roughly 6-6.5% next year. It is hard to say whether the government is willing and able to begin fiscal consolidation. In the current economic situation, characterised by high unemployment, this is relatively unlikely. In fact, after the surprising resignation of Finance Minister Belka most observers expect the new Finance Minister Kolodko to pursue an even looser fiscal policy.
Moreover, the Polish government has lately been fairly critical of the privatisation of state-owned companies. Wieslaw Kazcmarek, the treasury minister, has so far pursued a conservative policy. This has led to uncertainty on the part of international investors, and some major investment projects have instead been realised in the Czech Republic and Hungary. The capital account has thus registered a decline in foreign direct investment. It must be feared that this trend will continue if the Polish government fails to prove its determination to get on with privatisation.
But there is some good news, too. Substantial progress has been made in the accession negotiations with the EU – the controversial chapter on the free movement of capital has been closed successfully. Agriculture, the most controversial chapter, has yet to be tackled, however. As a large part of the Polish workforce is employed in the agricultural sector and the Polish Peasants’ Party forms part of the ruling coalition, the EU’s suggestions regarding direct payments to farmers are of particular political interest in Poland. The EU proposes that support to farmers in the new member states should only amount to one-quarter of the subsidies granted to farmers in the old member states. This will hardly go down well with the Polish government.
It should be noted that economic weakness has led to Poland’s falling behind in the convergence process. An economic upswing will be necessary for Poland to catch up with the top group of accession candidates. In addition, it is important for Poland to return to a growth path if it wants to create a positive environment for the referendum on EU accession. And finally, an upturn would make budget consolidation – which is currently unlikely to be implemented however – considerably easier. At present, the deficit ceiling of 3% of GDP prescribed by the Maastricht Treaty is not within reach for Poland. We therefore do not think that EMU membership before 2008 is a realistic scenario.
Hungary: market reforms stay on track
The Hungarian economy remains on a solid growth path and will probably post 4.0% growth this year. The DB Research convergence indicator shows that Hungary already achieved a remarkable degree of real economic convergence last year. However, there will likely be little progress with convergence this year – owing to higher budget deficits on the budget and current account deficits.
Inflation has fallen noticeably over the last twelve months: in May 2001 it still stood at 10.8% but was down to 4.8% in June 2002. Even though the inflation rate will be considerably lower than last year, the central bank is unlikely to meet its 4.5% (+/-1%) inflation target by the end of 2002.
The new government, consisting of Socialists and Free Democrats, which came to power in April, appears to have overcome the first political crisis. Like its centre-right predecessor, the new government pursues a market-oriented economic policy. In the mid- 1990s, a coalition of Socialists and Liberals already succeeded in stabilising the Hungarian economy. The new government has announced that it will continue to support the central bank’s stability-oriented monetary policy and stick to the current exchangerate regime – which keeps the forint within a fluctuation band of +/- 15% versus the euro. However, it has also indicated that it is more interested in growth than in price stability – at least more so than the previous government.
One of the main reasons why the central bank looks set to miss its inflation target is the expansionary fiscal policy launched in the runup to the parliamentary elections. First, the Conservative government decreed an increase in old-age pensions prior to the election. After the elections, the new Socialist government raised public-sector wages, which was one of their election promises. As a result, government expenditure is on the rise and – with roughly unchanged tax revenues – so is the budget deficit. Given the fact that local elections are scheduled for autumn, the government is unlikely to introduce a determined consolidation policy this year.
The budget deficit looks set to reach about 4% of GDP this year – if EU accounting standards were applied, it would even amount to roughly 5%. Despite the current deficits, though, there will be no dramatic deterioration in government debt. Debt will reach around 55% of GDP this year.
The government plans to bring down the public-sector deficit to 2.0- 2.5% of GDP over the medium term – i.e. by 2006. If economic growth remains as high as in the last few years, this goal is attainable. However, it will require the government to reform its fiscal policy at the latest after the autumn local elections. Spending cuts will be inevitable.
All in all, the positive economic development in Hungary has benefited the convergence process. But over the medium term, fiscal policy must be consolidated. Such consolidation would help bring inflation down further. Following EU accession, fiscal discipline could help Hungary meet the Maastricht criteria in several years’ time. There would then be no obstacle to EMU membership, the declared goal of the government and the opposition parties, at some point after 2007/2008.
Czech Republic: convergence far advanced, budget deficit too high
Further progress has been made with real economic convergence in the last few months. Solid growth of 3.5%, lower current account deficits and considerable FDI inflows have contributed to the catching-up process. The positive development is reflected in the DB Research convergence indicator, which rose to 74.6 in 2002 from 72.9 in 2001. The Czech Republic thus still belongs to the top group among the accession candidates, which have already achieved a considerable degree of real convergence.
The stable monetary environment prescribed by the Copenhagen criteria has already been achieved in the Czech Republic in the last few years. Inflation risks are small this year, too. The inflation rate declined from 4% in January to 1.2% in June. Even if inflation picks up in the second half of the year, due to higher oil prices and accelerating growth, the Czech central bank will still be able to meet its inflation target of 4 (+/-1)% by year-end.
The combination of low inflation and positive growth prospects has led to considerable capital inflows and hence to an appreciation of the Czech koruna. Since the start of the year, the koruna has firmed from CZK 32/EUR to under CZK 30/EUR. Despite occasional forex market intervention and a rate cut in April, the currency broke through the CZK 30/EUR resistance level. Even though Czech exporters deplore the strong exchange rate, the effects of the appreciation are so far hardly visible in the trade statistics.
The Czech budget continues to give cause for concern: although the economy looks set to grow by roughly 4% this year and next, we expect a budget shortfall of about 4% of GDP – adjusted for privatisation proceeds the deficit would even come to 9% of GDP. With privatisation revenues set to decline over the medium term, a sharp correction of fiscal policy is urgently required. The environment is favourable at present. Public-sector debt barely totalled 20% of GDP in 2001, so debt payments have little weight in the government budget. Given the high fiscal deficits, the debt level will likely rise to more than 25% by 2003, unless the budget shortfall can be made up with the help of privatisation receipts.
It is rather unlikely that the new government led by the Social Democratic leader Vladimir Spidla will bring about a determined turnaround in fiscal policy. The new government is commanding only a tiny majority in parliament. This will make it difficult to push through spending cuts in the budget. In fact, the coalition agreement does not foresee any dramatic fiscal adjustment over the next 2-3 years. As regards foreign policy, the new government can be expected to pursue an EU-friendly course.
All in all, the positive economic development in the Czech Republic has led to a remarkable level of convergence. We continue to see risks in the area of fiscal policy. Especially in view of potential EMU accession, decisive measures are required here. The recent political upset in connection with the heated pre-election discussion about the Benes decrees is unlikely to delay EU membership, though.
Slovakia: new risks in the race to catch up
Overall, the Slovak economy has developed favourably in the current government’s term of office, which is nearing its end. Stability and competitiveness have increased thanks to a combination of stabilisation measures and structural reforms. GDP growth has been more than twice as high as in the EU countries recently, inflation has slowed, and other key indicators, too, initially developed positively after the elections in autumn 1998. In addition, the heterogeneous ruling coalition has provided realistic prospects for speedy accession to the EU and NATO. Irrespective of the successes achieved, chronic quarrels within the coalition have repeatedly delayed or even prevented solutions to key reform projects (e.g. reforms of old-age provisioning or the healthcare system) and led to renewed macroeconomic distortions in some areas.
Following two years of stabilisation-induced contraction, domestic demand picked up again strongly in 2001 and took over the role of growth pillar from foreign demand. While investment in plant and equipment was particularly dynamic at first, private consumption has recently been gaining momentum: it benefits from the fact that real wages were up slightly in 2001 (-4.0% p.a. in 1999/2000) and will probably grow strongly in the election year 2002. This means that a slight increase in growth to 3.5% of GDP from 3.3% in 2001 looks attainable. But unemployment will likely remain very high for the time being.
The current-account deficit, which had declined by two-thirds until 2000 (from around 10% of GDP in 1996-98), was back at an alarming 9% of GDP in 2001. For a large part, this was the result of an import pull for capital goods, triggered by lively investment activity, which will likely boost the country’s competitiveness in the future. However, the widening of the deficit on the trade balance and current account is increasingly due to rising demand for imported consumer goo ds. As exports will continue to be hampered in the foreseeable future by the EU’s persistent growth weakness, there is little leeway for a reduction in the current-account deficit; a decline by more than one percentage point to 8% of GDP in 2002 seems hardly possible.
The development of inflation is very encouraging. It currently reflects weak global demand, the central bank’s stability-oriented monetary policy and slower price deregulation in the current year. While it was well into the double-digits two years ago, inflation recently barely exceeded the Euroland level, at less than 3% yoy. Although inflation will likely pick up again in the further course of the year, it should definitely be within the central bank’s target range of 3.5-4.9% in December.
Despite its successful fight against inflation, the central bank has not lowered interest rates in more than a year but even raised them by 50 bp at the end of April – to highlight the government’s overly lax fiscal policy. The public-sector deficit of 5.4% of GDP for 2002 agreed with the IMF (after 4.8% of GDP in 2001, both including the cost of restructuring the banking sector and using state loan guarantees) will probably be exceeded markedly and come to an estimated 7% of GDP. The budget deficit will fall to almost zero in 2002, provided that privatisation proceeds are added to government revenues. For one thing, though, privatisation receipts only affect a limited number of years and, for another, they are extraordinarily high this year because of one privatisation project (SPP gas company) in particular. If this factor is taken into account, the hole in the government’s coffers is clearly too big.
Besides the high current-account and budget deficits, there is a serious political risk, too. The HZDS, the party of former Prime Minister Vladimir Meciar (who was voted out of office in autumn 1998) which had pursued a policy of confrontation vis-à-vis the EU and NATO during his term, still has a major lead in the opinion polls. Meanwhile, both Meciar and the HZDS claim to support Slovakia’s membership in both organisations, with no apparent reservations. But major Western politicians doubt this change of heart and have warned explicitly that a new Meciar government would do considerable harm to Slovakia’s accession efforts. Even though the most likely scenario is the formation of a new Western and reformoriented coalition without the HZDS, the alternative – a coalition government under Vladimir Meciar – cannot be ruled out entirely. If this were to be the election result, EU and NATO membership could be delayed, which in turn would make it more difficult to ensure the stability of the Slovak economy.
The developments described above are reflected in our convergence indicator. Following a strong positive impetus in the first half of the government’s term, economic problems which returned in part in 2001 led to stagnation and will allow for an only slight improvement in the current year.
Despite some progress with the EMU convergence criteria, especially as regards price stability, there are many questions as to later EMU membership. One important aspect is the schedule for further price deregulation. The central bank favours completion of the deregulation before EMU entry. As there is still considerable need for action in this context – especially regarding energy prices – a realistic time frame for Slovakia’s EMU membership is five years at least.
The Baltic states: on course for the EU
EU membership seems on the cards for the Baltic states. And accession to NATO – just as important politically – will likely be reality in November. Overall, the region achieved remarkable growth in a difficult global environment last year. At more than 6%, growth was markedly higher than the average achieved by the Eastern European accession candidates, where the rate of expansion came to only about 3%.
Estoniacontinues t o rank first in the Baltic states’ convergence rating. The DB Research indicator suggests the “Baltic tiger” will be among the top group this year and next. Over the past years, however, Estonia’s lead over Latvia and Lithuania has narrowed. Since the new government came into power in January, Estonia has been politically stable and pursued a market-oriented economic course. The most important foreign policy goals for the new coalition consisting of the reform party and the centrist party under Prime Minister Siim Kallas are still EU and NATO membership. Economic growth will likely slow somewhat this year from a remarkable 5.4% in 2001. We also expect inflation to decline to 3% this year, from an average of just under 6% in 2001. This year’s relatively high current account deficit will again be financed largely by foreign direct investment. The public finances give little cause for concern or criticism: thanks to high growth, a budget surplus was achieved last year; for the current year we expect a small deficit because of higher expenditure and more moderate growth. With a private-sector share of about 75% of GDP, privatisation is well advanced in Estonia; the Narva power station, however, has not yet been privatised. Nonetheless, the energy chapter- which is still open in the accession negotiations – is scheduled to be closed soon.
With growth of 7.6% in 2001,Latviaoutstripped its Baltic neighbours. The country thus registered another year of high expansion with very low inflation rates. For the current year, we look for more moderate growth of 5%. The upswing has contributed markedly to the increase in the DB Research convergence indicator. Increasing incomes have also led to a relatively stable domestic climate despite the upcoming parliamentary elections in October. As regards foreign policy, Latvia’s first priority is also NATO and EU membership. The budget deficit gives cause for concern: it looks set to widen considerably in the election year. Even though a deficit of 1.5% of GDP has been agreed with the IMF, a shortfall of 2.5% must now be expected. Moreover, the current account will probably post a very high deficit again this year (roughly 8.5%). New trade legislation, in effect since January, could mean higher inflows of urgently required FDI in future.
Lithuania, too, has seen a pronounced increase in the DB Research convergence indicator over the last few years. The largest economy among the Baltic states registered dynamic growth of 5.7% last year. This year, growth looks set to weaken markedly, though, as in the neighbouring countries. Following the change of government in mid-2001, the new government led by the Social Democrats continues to pursue a market-oriented reform course. Thanks to the agreement achieved in June 2002 with the EU on the closure of a Soviet-era nuclear power plant, the energy chapter in the EU accession negotiations was closed. Another encouraging aspect is successful fiscal consolidation over the last few years: the budget deficit was almost halved last year and fell from 2.7% to 1.7% of GDP; in 2002 it could decline further. Despite the positive economic development, unemployment remains relatively high (12%). On the one hand this reflects necessary restructuring, on the other the high unemployment rate is due to a lack of mobility and qualification.
The fact that the changeover in February this year from a dollar peg to a euro peg for the national currency, the litas, caused no problems underlines Lithuania’s orientation towards the EU. The currency-board regime should continue to help keep inflation rates low. In view of participation in the ERM II and subsequent membership in EMU, it remains to be seen whether the currencyboard strategy will prove superior to more flexible exchange rate regimes.
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