Further progress on convergence

Further progress on convergence

With only a few months to announcement of the conclusion of accession negotiations with what will probably be eight Central and Eastern European countries, debate is honing in on “last-ditch” risks that could still delay their EU membership.

So far, the financial markets have been unfazed by such concerns. Basically, interest rate convergence in the 10-year maturity range is already far advanced, given that these countries are expected to join EMU within that period. Interest rates are particularly low in the Czech Republic, although it could join EMU possibly not until 2010 owing to the new direction in budget policy.1 In Poland and Hungary the spread is roughly comparable to that in Spain before it joined the euro.

We examine economic readiness for membership with reference to our convergence indicator. The results are broadly in line with the assessment of the European Commission’s annual progress reports. In its 2002 reports, the Commission stated that all CEE-8 countries have achieved a sufficient level of convergence to join the EU. Our convergence indicator has monitored economic developments in the region for the past two years, building on our ongoing estimates of key macroeconomic indicators and the institutional framework. With the indicator we deliberately track only the economic and institutional aspect of the Copenhagen criteria. Before going into the economic situation in the accession countries, we would therefore like to discuss the not inconsiderable political risks currently forming the subject of debate with regard to the countries known as the “Visegrad four” (Poland, Hungary, Czech Republic, Slovakia). This is followed by an analysis of the general economic situation in the candidate countries, with our convergence rating for the current year and an outlook for 2003. We conclude with a more detailed discussion of the present economic position in Poland, Hungary and the Czech Republic.

Remaining political risks in the candidate countries

For some of the political risks on which debate had focused in recent weeks solutions look to be in the making. A new EU proposal appears to have brought the transit problem surrounding the Russian exclave of Kaliningrad, which would be sandwiched between the new EU members Poland and Lithuania after enlargement, closer to settlement. Following the parliamentary elections in Slovakia, former premier Vladimir Meciar’s party will not belong to the government, dispelling fears that Slovakia might depart from its goal of EU and NATO membership.

In Poland political controversy still rages on agreement to the proposals that the EU looks set to put forward on agricultural policy. Although the Union has not yet adopted a common stance on this issue, its “offer” will likely be close to the EU Commission’s January proposal, which initially provides for far lower direct payments to farmers in the candidate countries. With the Polish Peasants’ Party a member of the ruling coalition government, it will not be easy for Poland to accept this. There is also a danger of heightened populist tendencies at the October 27 local elections, which would further narrow the government’s political leeway. At present Poland is considering the possibility of increasing payments to farmers from its national budget. Ultimately, though, we expect it to accept the EU’s proposals; indeed, the aim of early EU membership leaves the country hardly any other choice. Recent comments from the competent Polish ministries also point in this direction.

Domestic political bickering has recently erupted over Hungary’s EU membership. In the lead-up to local elections the former prime minister and present opposition leader, Victor Orban, declared he was prepared to back the constitutional amendments necessary for Hungary’s accession to the EU only under certain conditions. He is de manding that the government led by Prime Minister Medgyessy in office since April abide by a plan to support small and mediumsized companies, hold open the possibility of granting loans to family-run farms, take account of domestic companies in tenders for public contracts and step up pay increases. Regardless of whether the government defers to opposition demands, we ultimately expect the constitutional amendment to get through parliament. After all, all four parliamentary parties have reiterated that EU membership has top priority for Hungary. Were the domestic confrontation to come to a head, there remains the option to call new elections, which would possibly give the ruling coalition alone the necessary two-thirds majority.

A domestic political spat in the Czech Republic over how to finance the flood damage propelled the administration under Vladimir Spidla to the brink of a government crisis. Although the government’s survival has been secured for the moment, its wafer-thin parliamentary majority is a potential factor of uncertainty for Czech politics.

On completion of the accession negotiations the accession treaty must be ratified by the old members of the EU and also by the candidate countries. Approval by the parliaments of the would-be members is very likely, but referenda still have to be held in most of the candidate countries. Opinion polls point to general acceptance, making it unlikely that the necessary yes-vote or mandatory turnout will not be obtained. It looks as though the Visegrad countries intend to hold referenda one after the other in the late spring of 2003, with Hungary, which has so far posted the highest EU membership approval ratings, making a start in May or June 2003. In the summer of 2003 referenda will probably be held in all three Baltic states. Even if one of the candidate countries were to throw out the accession treaty – ultimately a very unlikely eventuality – all other countries could still join the EU as planned.

Robust growth despite economic weakness in Western Europe

The Central and East European economies have weathered the difficult economic situation in practically all other parts of the world comparatively well so far. But with growth prospects in Euroland – and most particularly in Germany, the major trade partner for most Central and Eastern European countries (CEEC) – having had to be revised substantially downward, there is still concern that growth in Central and Eastern Europe might also slow appreciably. However, the growth outlook in the region has proved relatively robust, as expansion in most of the countries is driven mainly by domestic demand. We expect the group consisting of Poland, Hungary, the Czech Republic and Slovakia still to notch up growth of almost 2% this year. Without Poland, which is still in the throes of a homemade economic crisis, the growth rate would top 3%.

The Baltic states are expected to turn in growth of 4.5% in 2002, with Estonia, Latvia and Lithuania being buoyed by dynamic domestic demand. Developments in Lithuania have been spurred by robust expansion of 4% in Russia, which still absorbs around 11% of its exports. On a lesser scale, the same is true of Latvia, while in Estonia the realignment of trade to Western Europe has made the greatest headway. It is notable that the focus on trade with the West – in itself desirable in terms of EU membership – is currently having a rather negative impact on the trade balance at present. At 2.5% this year, growth in Slovenia will also be slightly lower. Expansion rates in the region next year could be ratcheted up by a half to a full percentage point, providing that economic activity gradually starts to bounce back in Western Europe.

2002: Progress on convergence in a difficult environment

The slightly lower growth prospects have not altered the candidate countries’ relative positions with regard to real economic convergence since our last assessment in June. The Deutsche Bank Research convergence indicator, which monitors the degree of economic maturity achieved by the candidates with reference to 16 individual variables, again puts Slovenia, the Czech Republic and Hungary out front.

Because of Hungary’s high “twin deficits” – in its state budget and on the current account – the country has, however, fallen slightly behind. In the Czech Republic the sharp decline in inflation and lower growth – due not least to the damage caused by the floods – balance each other out in terms of the indicator; as a result the convergence level is practically unchanged on our last assessment. Estonia, Latvia and Slovakia follow with convergence values at around 70% of the EU average, with Lithuania not far behind. This confirms for 2002 the trend indicating that the most promising countries of the former “Helsinki group” – Latvia, Lithuania and Slovakia – have made the greatest headway, Estonia having already caught up with the leading group some time ago. Slovakia has taken another leap forward on our last evaluation, as inflation continues to fall and its current account deficit will be lower than expected. The persistent weakness of Poland’s economy and the attendant rise in unemployment has depressed the convergence indicator. This means that in 2002 Poland brings up the rear of the eight candidate countries that will presumably make up the first round of EU enlargement.

Bulgaria and Romania have achieved remarkable growth rates with what has, all in all, been a successful reform policy. However, these countries do still have a comparatively greater need for catch-up. While Bulgaria will this year already notch up a per capita income – in terms of its domestic purchasing power – approaching that in Lithuania and Latvia, Romania is farther behind in this respect. Our convergence indicator makes allowance for this. Countries with greater catch-up requirements must achieve higher growth to obtain the same growth dynamics scores as countries that are already more advanced.

2003: Home-made problems will prevent further catch-up

On the basis of our forecasts for 2003 the convergence indicator shows a similar picture to this year. Following significant progress in the last few years, the accession countries are now finding it increasingly difficult to maintain the pace of catch-up. In a number of the areas we examined, such as inflation, some countries have achieved almost complete convergence. It may be assumed that closure of all the 31 chapters the EU is negotiating with the eight Central European accession countries will bring about further improvement in the institutional indicators (legal system, banking sector, competition policy). Moreover, growth in all countries should come in higher than next year, making a slight drop in unemployment likely. In some cases, however, this positive outlook is overcompensated by country-specific difficulties (usually excessively high deficits in public budgets and on current account, inflation picking up again slightly in some countries), as a result of which some countries will even drop behind slightly in our convergence rating.

Of the countries in the leading group, the Czech Republic will suffer a slight setback given the substantial increase expected in its budget deficit and an uptick in inflation. Hungary, in contrast, will register progress, as we expect inflation and the budget deficit to drop a little. Poland is likely to achieve the strongest improvement in the indicator on the back of a gradual economic rebound.

Poland: Economic recovery uncertain

But in autumn 2002 the economic crisis in Poland persists – very few observers were surprised that second-quarter GDP crawled up a mere 0.8% year on year. Leading indicators of economic activity in Poland paint a mixed picture. July industrial output – stimulated partly by one-off factors – jumped 5.7% year on year, only to slump 1.2% in August, although this was partly due to a working-day effect. Recent strong exports further improved current account. Nonetheless, we are looking for growth of only about 1% this year. This could pick up again to 2.5% in 2003, but recent government forecasts of 3.5% seem over-optimistic, particularly given only gradual recovery in Euroland, especially Germany.3 This means that next year, too, Poland will fall well short of the high rates of expansion it was able to generate in the mid-1990s.

Inflation has hit ever-new lows in recent months. Having dropped to 1.6% in June, price rises slowed further to 1.3% in July, easing yet again in August to just 1.2%. The exceptionally strong reduction in food prices during the summer months certainly played an important part here – they do, after all, make up roughly one-third of the consumer price index. But core inflation has also receded, due not least to sluggish consumer demand reflecting the present state of the economy. We therefore expect inflation to pick up only moderately, barely topping 2% by the end of the year. In the medium term it should stabilise at between 3 and 4%.

The Polish central bank responded to the very low level of inflation in recent months and to assessments – which we share – of only marginal medium-range inflationary hazards with further rate cuts of 50 bp each at the end of August and then again at the end of September to 7.5%. Yet real interest rates in Poland are still comparatively high. However, a “Monetary Conditions Index” for Poland does indicate an overall easing in the monetary environment. In addition to real interest rates, this index also allows for developments in the real exchange rate. Further major rate cuts by the central bank are therefore not certain this year, given that fiscal policy is still also causing the bank concern.  

Although the Polish finance minister, Grzegorz Kolodko, was at pains after taking over office in the summer to signal that he did not stand for loose fiscal policy, as feared by many observers, the outlook for a determined reduction in the budget deficit is still not good. This year’s deficit will work out at more than 5% of GDP, and next year it will hardly be possible to cut the deficit ratio either. Although spending cuts are basically targeted, various “anti-crisis” measures to pump prime the economy point rather in the opposite direction. The 2003 budget is based on a very upbeat growth forecast of 3.5%. Real spending increases of more than 2% mark an obvious departure from the disciplining rule “inflation +1%”. We consider GDP growth of only 2.5% realistic next year; as a result there is unlikely to be any significant budget deficit trim.

Hungary: Economic imbalances in the budget and on current account

Because of the downswing in Western Europe, economic growth in Hungary has slowed, although it will still stand at a comparatively robust 3.5% this year. The rate of expansion is being checked mainly by mounting imports and sinking exports. Given an upswing in Western Europe, next year could see growth of 4% again.

The gratifying decline in inflation since spring 2001 has ground to a halt this year. New inflation risks – primarily from a widening of the budget deficit – prompted the central bank to raise interest rates in the summer by 50 bp. Further rate hikes could be necessary if the government does not launch a fiscal policy turnaround. In August the budget deficit had already reached 130% of the target level and will probably work out at almost 6% of GDP this year. But in view of robust growth, the economic situation does not appear to call for expansive fiscal policy. Government spending has been ratcheted up heavily ahead of the local elections – with its 100-day plan the Medgyessy administration has honoured its election pledge to raise earnings for public sector employees. Next year the government plans to shave the deficit to 4.5% of GDP. But to achieve this ambitious target it will have to run government expenditure down decisively after the local elections, otherwise it runs danger of new borrowing hitting 5.0 – 5.5% of GDP again.

This year’s current account deficit will probably soar to 4.5% of GDP, twice as much as in 2001. The bulk of the deficit stems from a poor services balance, which is suffering from shrinking tourism receipts. Since direct investment this year will be well down on 2001, the current account deficit gives cause for some concern. Next year we expect exports to recover, bringing an improvement on current account. The government aims to trim the budget deficit sizeably in the medium term. But to meet the Maastricht criterion of 3% of GDP by 2004/2005 and hence qualify for European Monetary Union, fiscal policy will have to be turned around dramatically after the local elections, and economic growth will need to pick up.

Czech Republic: Flood damage damping growth

Owing to slower growth in Western Europe and flood damage, the Czech economy will expand at a rate of only 2.5% this year. However, the floods will have little repercussion on inflation. Since rural areas were less severely hit than in 1997, no increases in food prices are evident so far. Lower gas prices and more competition in the telecommunications sector should prevent inflation moving much above the 2% mark on average for this year. In July and August it was only 0.6%.

Flood relief from the EU and other sources has boosted capital inflows into the Czech Republic, keeping the Czech koruna under appreciation pressure. An interest rate cut by the central bank and direct intervention in the foreign exchange market have done little so far to halt this trend.

Estimated at almost 5% of GDP this year, the deficit on current account will, like 2001, be a hefty one – partly in the wake of falling tourism receipts as a result of the flooding. But since the Czech Republic attracts by far the most foreign direct investment in the region, this deficit gives no cause for concern. Following further major privatisations in 2002, the country can look forward to net FDI worth around USD 8 bn. That is equivalent to almost 12% of GDP and far exceeds the negative balance on current account.

The Czech economy’s sore spot is still the public budget, which will notch up a deficit this year of more than 4% of GDP. Most of the funding to repair the damage caused by the floods will come from next year’s budget and can therefore hardly be held accountable for the 2001 shortfall. Stripping out the proceeds from privatisation, the Czech budget deficit is equivalent to almost 10% of GDP. Since privatisation revenues will decrease in the medium term, a determined course correction in fiscal policy is urgently necessary. At present, though, the government looks set to pare the deficit only gradually, possibly not aiming to join EMU until 2010.

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