Six months to Copenhagen: convergence process supports road map for enlargement

Six months to Copenhagen: convergence process supports road map for enlargement

Despite the problems surrounding the eastern enlargement process much suggests that the EU will announce the participants of the first round at the European Council to be held in December under the catchy motto “From Copenhagen to Copenhagen”. Copenhagen was the setting for the EU summit in 1993 at which the criteria for new membership were hammered out in detail. The same location could see the accession plans of eight Central and Eastern European countries (CEEC) plus Malta and Cyprus – the so-called Big Bang scenario – turn into reality in the current year. The risks remaining for the European Commission’s road map are by no means trivial – some of the main issues: chapter on agriculture, Ireland and Cyprus. But it is still likely that in October the EU will name the countries for which – on the basis of the Commission’s regular reports on progress – the accession negotiations will be officially declared concluded in the Danish capital in December.

With six months to go before this decision, the purpose of this article is to take a closer look at the level of economic development in the candidate countries. With the help of the Deutsche Bank Research convergence indicator we have been monitoring the degree of economic convergence between the candidate countries and the EU for almost two years. The findings have been factored into our accession scenarios and have enabled us to draw valuable conclusions about the status of development in these countries. This article shall first give an overview of the methods, sense and purpose of the convergence indicator, and then outline the contours of the convergence process over the past five years and capture the economic profile of the Big Bang countries – also in comparison with the EU’s southern enlargement in 1986.

Accession criteria and convergence process

The EU criteria for new membership, the “Copenhagen criteria”, set political, economic, legal and administrative hurdles in the way of the Central and Eastern European countries on the path to accession. Since political maturity was a general prerequisite for the commencement of accession negotiations and since the assumption and implementation of the acquis communautaire has been, and remains, a tedious and complex legislative process, the candidates’ progress can only be quantified with regard to the economic criteria.

This is the approach taken by the Deutsche Bank Research convergence indicator. It reflects the economic accession criteria as precisely as possible and attempts to determine the degree of economic maturity achieved by the candidates. Of course the economic criteria of “functioning market economy” and “capacity to withstand competitive pressures and market forces within the Union” cover a relatively broad spectrum (see boxes to the right), so that the selection of the individual indicators is crucial. It is all the more important to bear in mind that, given the focus on economic maturity, variables such as the number of chapters closed in the accession negotiations or political developments should not be included in a real economic convergence indicator. Similarly, shortterm interest and exchange rate developments are irrelevant for EU membership.

Since the convergence indicator is confined to the economic criteria, it does not reflect the probability of accession for the respective country on a one-to-one basis. Economic developments play an important role in the accession process and can positively, or negatively, affect the other criteria. However, it would be a grave mistake to underestimate the significance of political factors which are often independent of economic developments. This limits the insights to be gathered from the Deutsche Bank Research indicator, but the results are clearer. How do the countries measure up against each other in terms of relative economic development? Which countries are better prepared economically than others? Do the groups referred to in the political debate make economic sense?

How does the convergence indicator work?

The structure of the indicator shows two things: first, the intention of obtaining a more reliable picture of economic development by using a raft of data than would be possible in an ad hoc comparison of single parameters. Second, all the selected indicators are given the same weight in the interest of transparency. Using 16 variables, the convergence indicator reflects a true cross-section of the economic structure of the respective country. Arbitrary, nonverifiable weightings were avoided. The reference value for our calculations is the respective average figure of the EU-15. However, the absolute values of the indicator should be interpreted with caution. What is more significant is that the indicator allows comparison of the countries, i.e. it gives a good description of their relative degree of preparation. Individual strengths and weaknesses emerge visibly.

The 16 variables of the convergence indicator can be broken down into five groups:

• Real economy, with the indicators GDP per capita (at purchasing power parities), unemployment rate, shares of the agricultural and the private sector in GDP.
• Growth dynamics, with the GDP growth rate and productivity growth as “catch-up indicators”.
• Economic policy and institutions, with four individual indices for the legal system, the competitive framework for business, the banking sector, and the liberalisation of trade and the foreignexchange markets.
• External sector, with the figures for the current account balance and foreign direct investment as percentages of GDP, and trade with the EU as a percentage of total foreign trade.
• Monetary and fiscal policy, with the indicators inflation rate, budget deficit and general government debt.

From top three to top four

This – our eighth – update of the convergence indicator confirms a development which we observed for the past few months: things are moving at the top. Previously, the structural convergence criterion divided the field of candidates into four groups: the top group consisted of Slovenia, Hungary and the Czech Republic, followed by those slightly above the average, i.e. Estonia and Poland, and trailing them at a short distance were those slightly below the average, i.e. the three best-positioned countries of the Helsinki group, Slovakia, Latvia and Lithuania. Bulgaria and Romania followed far behind. On the basis of the revised data for 2001 and the estimates for 2002, Estonia has become firmly established in the top group and with a convergence level of 72% in 2002 is now closer to the leading three candidates – Slovenia (75.6%), Czech Republic (74.6%) and Hungary (73.2%) – than to Poland (65.2%). At the same time, Slovakia (67.5%), Latvia (67.7%) and Lithuania (65.2%) have meanwhile caught up to or outpaced Poland. Bulgaria (58.7%) and Romania (57.5%) continue to trail the field of candidates despite considerable progress in the past few years.

Strengths and weaknesses at the top

The strengths and weaknesses of the individual countries can be gauged by looking at the five indicator groups. Slovenia continues to stand out for its uniform, high level of convergence in all segments. It has achieved over 60% of the EU average in each of the five categories. Hungary’s strengths lie in its unbroken growth dynamics and well-developed institutional environment. Progress has been relatively weak in the area of fiscal and monetary indicators. The widening of the budget deficit in the current year, while the general government debt level is still relatively high and inflation easing only slowly, prevents a better assessment. It follows logically that the Czech Republic moves ahead of H ungary in 2002, especially in the light of the former’s very strong external position. Relative to GDP the Czech Republic will probably attract around three times as much FDI as Hungary or Poland this year. The chronically shaky condition of the state’s finances, whose deficit will come to about 9% of GDP again this year when privatisation receipts are stripped out, remains the Achilles’ heel of the Czech Republic. Estonia is the latest member of the new top club: steady progress in the real economic and institutional indicators have vaulted the Baltic state into the top of the candidate rankings.

The new midfield

Poland was the region’s economic problem child in the past year, and will remain so this year: no applicant country has had slower growth in the course of this year. After running neck and neck with Estonia for a long time, Poland is the only country of the Luxembourg group to have fallen behind – despite still good scores on the institutional indicators – relative to other candidates. The strong decline in the inflation rate in the past few months is scarcely reflected in the indicator since the positive effect is cancelled out by the widening of the budget deficit to more than 6% of GDP. Nevertheless, there is no reason to trivialise Poland’s success in pushing through reforms over the past decade. Disregarding the current economic problems, which were triggered by an improper fiscal and monetary policy mix, Poland’s situation is not that bad. If it would achieve moderate growth of 3% in this year, Poland’s reading for 2002 would already improve ceteris paribus to about 69% and the country would thus return to a position within reach of the top group.

Slovakia, Latvia and Lithuania continue to boast high growth rates in a steadily improving institutional environment. Over the past few years they have closed the initial reform gap separating them from the Luxembourg countries, in some cases at a breath-taking pace. The combination of solid growth and rapid institutional reforms enabled the countries to stage their impressive catch-up performance in the accession negotiations from early 2000. The remaining weak points are visible in the convergence indicator: especially the areas of external stability and integration of trade with the EU leave room for improvement. Unlike Slovakia, Latvia and Lithuania have enjoyed remarkable fiscal and monetary stability for quite a while.

No news in the Southeast?It would be wrong to believe that nothing has changed in the Southeast. All in all, reform policy has been a success in Bulgaria and Romania in recent years, and this has returned these countries to a relatively strong growth path – a fact reflected in the convergence indicator. With readings of 58.7% (Bulgaria) and 57.5% (Romania), the two countries of Southeastern Europe have in 2002 more or less reached the level achieved by Latvia, Lithuania and Slovakia in 1998. But a closer look at the contributing indicators shows that further advances will require more time. Especially the structural data (GDP per capita and the share of agriculture in GDP) show that they still trail far behind the EU and that the gap will only narrow on a medium-term horizon.

Heading for the Big Bang – the convergence process since 1998

One question has long dogged the debate on potential accession scenarios and group eligibility for EU membership. Are there any valid economic arguments for temporarily excluding certain countries from joining? And: is a Big Bang, i.e. the simultaneous accession of up to ten countries (eight from Central and Eastern Europe plus Malta and Cyprus), a possible and sensible step from an economic standpoint? The fact that the Big Bang would be the simplest solution, because it would cause the least resistance, dawned relatively early on most observers. Basing our arguments on the results of the convergence indicator we said two years ago that a group of this size could become a p ossibility from an economic perspective. The differences between the countries of the Luxembourg and the Helsinki groups were still relatively pronounced. But our forecasts indicated that the “laggards” in the catch-up process would likely gain momentum.

Looking back, the developments of recent years underscore the validity of this argument. The differences in the convergence levels within the large group have narrowed since 1998. They have become more homogeneous. For example, the gap between the two countries with the highest and the lowest convergence level has fallen from just over 15 percentage points (pp) in 1998 to about 10 pp now. This trend becomes all the more significant in a comparison of the average of the Luxembourg group with those countries of the Helsinki group which in our baseline scenario will be part of the first accession round (Latvia, Lithuania and Slovakia). On average, the five Luxembourg countries had a lead in the convergence ratings of 9.4 pp in 1998; this narrows to 5.3 pp in 2002.

Slovakia, Latvia and Lithuania boast greatest success At the same time it becomes clearly visible that the gap between the Big Bang group on the one hand and Romania and Bulgaria on the other remains constant (1998: 11.4 pp; 2002: 12 pp). Thus there is no sign of a trend towards a homogenisation of the entire field of candidates; on the contrary, there is a divergent trend among the five Helsinki countries. The differences in convergence level between Latvia, Lithuania and Slovakia on the one hand and Bulgaria and Romania on the other have increased from 5.6 pp to 8.7 pp. The conclusion to be drawn is obvious: the real star performers of recent years have been Slovakia, Latvia and Lithuania, whose economic success has removed the old boundaries between the Luxembourg and the Helsinki group.  

It is hardly surprising that these countries are among the ones which have posted the highest increases in the convergence rating over the past five years. On an annual average, the convergence level has improved by 2.3 pp in Latvia, 2.0 pp in Lithuania and 1.8 pp in Slovakia. Only the Czech Republic (2.4 pp) and Romania (2.0 pp) show similar increases; however, the readings for both of these countries are somewhat distorted as a result of crisis-induced low values for 1998. Estonia (1.4 pp), Hungary (1.0 pp), Slovenia (0.8 pp) and Bulgaria (0.7 pp) have made slower progress on the convergence path. Poland brings up the rear, managing to achieve a 0.4 pp annual increase only once and otherwise stagnating since 2000 due to weaker growth.

Economic profile of upcoming accession round

Our convergence indicator shows the average level of the countries of the upcoming enlargement round (excluding Malta and Cyprus) to be just over 70%. On average, the Luxembourg countries weigh in at 72% of the EU average, and the three Helsinki countries at close to 67%. The gap separating them from the remaining candidates, Bulgaria and Romania, which show a score of 58%, is considerable and – assuming optimistically that these two countries make good about 1.5 pp per year – is equivalent to a lag of about eight years. Hence, it can be argued from an economic standpoint that Bulgaria and Romania will not be ready for accession until several years after 2005, especially since the biggest differences are found in areas where changes take longest: structural characteristics of the economy. On this count, Romania and Bulgaria manage to achieve only 45% of the EU average, which contrasts with 65% for the countries of the first enlargement round.

The following trends are visible within the Big Bang group: The five Luxembourg countries have a lead on the three Helsinki candidates as regards the real economic parameters and the external sector. By contrast, the Helsinki countries show greater growth dynamics and are on firmer ground in terms of monetary and fiscal policy. Besides stronger growth it is mainly the more rapid pace of institutional reform in Slovakia, Latvia and Lithuania that has helped them to narrow the gap relatively quickly.

How do the enlargement candidates compare with Spain and Portugal?

For many reasons it is not that easy to compare the eastern enlargement of the EU with the moves southward to embrace Spain and Portugal in 1986. The most important reason is the much higher level of integration achieved by the EU since the 1980s in the course of the internal market programme. Nevertheless, observers are naturally interested in comparing the current enlargement plans with the generally successful integration of the two countries of the Iberian Peninsula, especially on the issue of how strongly advanced convergence with the EU must be in order for the candidates to be able to cope with competitive pressure and market forces in the single market. Therefore, we have calculated the convergence level reached by Spain and Portugal at the time of their accession using the methods of the convergence indicator. Note, though, that the results have to be qualified by the fact that the institutional indicators comparable with those which we have for the CEEC today were not available in 1986 and therefore could not be factored into the calculations.

Nevertheless, the findings are very informative. When Spain joined the EU it had a convergence level (measured against the EU average at the time) of 76.2%, and Portugal’s reading came to around 74.4%. Thus, the assessments for the two countries were in line with the current values for the leaders among today’s candidates; in other words, no higher than the level attained by Slovenia, the Czech Republic and Hungary in 2002. Of course, the average of the Big Bang group from Eastern Europe, at 70%, falls a clear 5 pp below the figure for Spain and Portugal at the time. The difference between Poland and Spain was also sizeable, exceeding 10 pp. But there are still two years to go before the accession of the CEEC, during which time further progress can be made. Since 1998 the group of eight accession candidates has narrowed the gap by 1.5% per year. Granted, the pace may slow as the level of convergence rises, but much suggests that at least the leading candidates will join the EU at the same, if not higher, level as Spain and Portugal, and the average of the accession countries will be only slightly short of the convergence level attained by the Southern Europeans.

Summary: economic rationale evident in the enlargement process

Despite the notable convergence level achieved, the structural differences within the EU will grow more strongly upon enlargement than was the case with the southern enlargement in 1986. Since, moreover, the accession of Spain and Portugal lowered the EU average, the even larger structural differences between the accession countries and the “rich” old members such as Germany and France are masked by the orientation to the EU average. This notwithstanding, it has to be stressed that in many respects countries such as Slovenia, the Czech Republic and Hungary no longer have to fear comparison with the cohesion countries of the EU.

The accession candidates have admirably withstood the battering that has rocked the emerging markets since 1998. Reforms have progressed noticeably in the past five years, not least as regards the important institutional indicators. The annual assessment and related publicity for the reform efforts has resulted in considerable peer pressure among the candidates. Today, most of the applicants are more likely to be struggling with the problem that their currencies have appreciated so much and their bonds have reached such high trading levels that many fear the spectre of a new speculative bubble. To give an example, the yield on long-dated government bonds issued by the Czech Republic is already 80 basis points below that of bonds issued by “rich” Norway.

The steady monitoring of the structural convergence p rocess over the past few years has provided valuable insights into the overall accession process. It has emerged time and again that enlargement is a process dominated by political factors. But at this juncture six months before the announcement on the countries to take part in the first round, the conclusion to be drawn is that economic and political factors have never diverged to the degree that the road map for enlargement lost touch with economic facts. Despite all criticism of the details and despite several political glitches, the European Commission’s annual regular reports on progress have played a major part in keeping the political debate attuned to economic reality. In this respect, at least the EU’s road map for enlargement has adhered to economic rationale which remains wanting in other areas such as agricultural policy.

For more analysis see the

Deutsche Bank Research website.