Will EU Money Be the Tune for New Members

Will EU Money Be the Tune for New Members' Catch-Up Song?
by Katinka Barysch

T he new member states should not expect EU money to lead to miracles. The most important ingredients of catch-up growth are a stable macroeconomic framework; supply-side policies that help markets to adjust quickly; and a well-trained, flexible workforce. EU aid will only make a positive contribution to growth in the region if it is firmly integrated into such an environment.

On May 1, 2004, 10 new members will join the EU, 8 of them relatively poor Central and Eastern European countries. Bulgaria and Romania may join in 2007. Even though eastward enlargement will increase the number of people in the EU by 25 percent, the new members together will add no more than 5 percent to the EU’s GDP, perhaps twice that if GDP is measured on the basis of purchasing power parity (PPP) exchange rates. According to Eurostat statistics, on average, GDP per head at PPP in the new Eastern European members will be around 40 percent of the current EU average, and only about 33 percent at alternative PPP estimates and 20 percent if GDP is measured at market exchange rates. In short, the new members are generally much poorer than the current EU members.

The income gap has fueled concerns in both the existing member states and the accession countries. The current members fear that they could be swamped by imports from the low-cost accession countries and that firms will relocate to the new member states, where labor is much cheaper and social and environmental standards are less demanding. Countries such as Austria and Germany are also concerned that an influx of workers from the East could increase unemployment and social tensions. For their part, the East Europeans do not want their expensively educated graduates and skilled workers to emigrate in search of better-paid jobs, leaving a pool of unskilled, low-paid workers back home. They also fear that now that trade barriers between the East and West have been removed and transport costs are falling, the West’s highly productive industries could simply supply the smaller Eastern markets through imports, at the cost of local production. Even if foreign direct investment keeps flowing in, they fear that it will finance only low-wage, low value added industries, while high-technology manufacturing and research and development will remain in the West.

Since it was set up in 1957, the EU has declared that reducing regional differences and, in particular, the backwardness of less developed regions—referred to in Brussels as cohesion and convergence—is one of its main objectives. In 1975 the EU, or European Community as it was then called, set up its first regional support fund. Since then it has made ever increasing sums available through a growing variety of programs generally referred to as structural funds. Once the East European countries join, they too will be eligible for EU regional aid. The experience with income convergence in the existing EU is, however, mixed. Some evidence indicates that the EU’s poorer members have grown, on average, faster than the richer countries, but this does not necessarily hold true for individual regions within countries. The following stylized facts seem to hold:

• Income levels in West European countries have been more or less converging since the 1870s. Convergence was particularly strong in the 1960s, when trade barriers came down and trade between European countries increased rapidly; however, convergence ground to a halt during the 1970s, and even went into reverse in the early 1980s. The trend toward converging incomes resumed in the 1990s.

• On the whole, the rate of catch-up has been slow, at an annual average of 2 percent in 1950-90. At that rate the East European countries would take around 30 years to halve the present income gap with the existing EU member states.

• A look at regions in Europe rather than countries gives a similar picture, but the trend toward convergence has been much less pronounced. In many countries, particularly the poorer, peripheral countries, the gap between rich and poor regions has actually widened significantly since the 1980s.

Looking beyond the aggregates, individual EU members have gone through very different growth trajectories (table 1). Portugal and Spain have narrowed the distance to EU average income levels, and Ireland has overtaken the average in the past decade. Greece, however, has only recently begun to make significant progress in narrowing the gap.

• Spain’s GDP per head was around 60 percent of the EU average in the 1960s. Catch-up growth rates followed trade liberalization and market-friendly reforms in the 1970s, but progress came to a halt in the early 1980s. Since the mid-1980s, Spanish GDP per capita has gradually risen to just under 85 percent of the EU average. Spain joined the EU in 1986, and subsequently became the largest recipient of structural fund money.

• Ireland started from a similar level in the 1960s; however, unlike Spain, it stagnated for the next two decades, with neither EU accession in 1973 nor the receipt of EU regional aid making much of a difference. By the mid-1980s its per capita GDP had crept up to around 70 percent of the EU average, but after the Irish government fully embraced policies based on free trade, low taxes, low public deficits, and stronger competition, growth took off strongly. Now Ireland has a GDP per head that is nearly 20 percent higher than the EU average, although its GNP and living standards are lower than this figure suggests, because foreign firms repatriate much of the profit earned from their Irish operations.

• Greece’s economy also stagnated for almost 20 years. Its GDP per capita was around two-thirds of the EU average when it joined the union in 1981, and the ratio did not change for a long time. Signs of catch-up growth have appeared only recently, since the government started to consolidate public finances ahead of its entry to the euro zone.

• Portugal has a mixed history of economic reform. It liberalized trade in the 1960s, but returned to heavy state intervention after the 1974 revolution. It returned to more market-oriented policies in the 1980s. Economic growth followed a similar pattern: GDP per head rose from 45 percent of the EU average in the 1960s to around 60 percent in the mid-1970s. It then remained around this level until the late 1980s, but since then has risen to around 70 percent of the EU average.

As with the Mediterranean countries, the Central and East European candidates started to open their economies to trade and investment from the EU well before joining the Union. By 2002 trade between the EU and the candidates was almost completely liberalized. In proportionate terms (or as a share of total trade), many of the candidate countries now trade with the EU as much as, or more than, the EU members trade with each other. Foreign direct investment flows from the EU into Eastern Europe have been strong for years, amounting to 5 percent of GDP or more in the case of the best performing countries. In theory, therefore, the candidate countries should be well advanced in the process of catching up with the richer EU states.

In practice, according to Eurostat figures, average per capita GDP in the 10 East European candidate countries now stands at around 40 percent of the EU average. Indeed, the gap between the average EU income level and that of the candidate countries has widened considerably since 1989. The EU’s real GDP grew by 30 percent between 1989 and 2002, whereas for the 10 East European accession countries the increase amounted to only 8 percent during the same period. The widening of the gap is mainly attributable to the sharp fall in GDP in most of the region immediately after the shift from central planning. However, the gap has not diminished appreciably even since the beginning of growth, generally in the mid-1990s, in part because of macroeconomic mismanagement in some countries; slowing structural change in others; and the impact of external shocks, such as the 1998 Russian financial crisis.

Available evidence suggests quite strongly that the accession countries have followed the pattern of the Mediterranean countries, in that recent economic growth has gone hand-in-hand with a marked widening of regional income differentials. The fastest growth has occurred in the regions centered on capital cities and in those geographically close to the EU. Smaller towns, rural areas, and the eastern parts of the accession countries have generally lagged behind, with poverty, high unemployment, and a lack of competitive industries characterizing the regions along the EU’s future eastern border with Belarus, Russia, and Ukraine.

If current trends continue, regional differences in the East European countries will continue to widen. This divergence in regional economic fortunes matches industrial specialization patterns. A reasonably well-developed infrastructure and a better-educated workforce has given East European capitals a head start compared with more remote regions. Foreign direct investment has done the rest, crowding into urban areas and western regions while tending to avoid the more remote eastern regions. As a result, the region’s capitals have experienced a veritable boom. According to official EU figures, Prague and Bratislava, for example, now have per capita income levels that are above the EU average, whereas unemployment in eastern regions is still rising, further eroding local income levels. There is therefore a prima facie case for the EU to concentrate its regional development efforts on the poorer, eastern regions of the new member states.

Under current EU rules, regions with a per capita GDP of less than 75 percent of the EU average automatically qualify for EU regional aid under the so-called Objective 1 facility (see the box). This means that almost the entire area of all the East European countries will be eligible for EU aid. If the EU maintained the current extent of redistribution (net payments or receipts as a share of per capita income differentials) after enlargement, the new members would be due to receive enormous sums. Latvia, for example, would receive transfers amounting to more than 13 percent of its GDP per year, and Poland would receive 8 percent. However, flows of this magnitude will clearly not be forthcoming, nor would they be easily absorbed. To begin with, the total EU budget is capped at just under1.3 percent of total EU GDP, with 0.46 percent of this amount allocated to the structural funds. In addition, the EU has capped structural fund spending in the new member states at 4 percent of the recipient country’s GDP, arguing that the newcomers would simply not be able to deal with any larger inflows, an issue often described as a lack of absorption capacity.

The EU’s 1999 Berlin summit set out how much the new members could expect to receive after they joined the Union (see table 2 and 3). In the current budget, which covers 2000-06, the EU has earmarked a total of €42.6 billion ($45.96 billion ) for the new members, of which more than half will be paid out through structural funds. Poland will be by far the largest recipient, with more than €11 billion, followed by the Czech Republic and Hungary, with €2 billion to €3 billion each. However, the money will be slow to come in. Both regional aid and agricultural payments (the other major spending category in the EU budget) will be phased in gradually after 2004. Moreover, structural fund projects have long lead times, and even common agricultural policy payments are only reimbursed with a delay. The European Commission expects that in 2004, the year of accession, the new members will receive transfers amounting to only 1 percent of their combined GDP, rising to 1.5 percent by 2006. This is much lower than the 3.6 percent of GDP Greece received and the almost 2 percent of GDP Portugal and Spain received. In per capita terms, the new members will get between €200 (US$215) and €600 (US$645) per head at the most in 2004-06, compared with the €1,000 to €1,500 per head Greece, Ireland, and Spain received during the last budget period.

Table 3. Cohesion and Structural Fund Allocations 
to the New Member States, 2004-06
(1999 prices)

Country	Cohesion fund (€ millions )	Structural fund (€ millions)	Total (€ millions)	Per capita (€)
Czech Republic	836	1,491	2,327	228
Estonia	276	342	618	441
Hungary	994	1,853	2,847	279
Lithuania	543	823	1,366	569
Latvia	461	575	1,036	296
Poland	3,733	7,635	11,368	294
Slovakia	510	1,050	1,530	289
Slovenia	169	237	406	203
Total	7,522	14,006	21,528	292

Note. Cohesion fund allocations are the author’s calculations based on the mid-range of the European 
Commission’s indicative share. Malta and Cyprus are not included.
Source: European Commission, “Second Progress Report on Economic and Social Cohesion”; author’s calculations.

Whether the new members will actually receive the allocated amounts in full is uncertain. The East European countries tend to have weak state administrations and little experience with either regional support policies or with handling large-scale fiscal transfers. The systems for applying for and implementing EU regional support are so complex that even current member states regularly fail to spend the full amounts they have been allocated. This problem will be much worse in the new member states. In addition, the new members will have only two years to identify projects and obtain Commission approval for their funding before the current budget period runs out (although they will not actually have to spend the money until the end of the decade).

The EU created a pre-accession regional aid facility, the Instrument for Structural Policies for Pre-Accession, to help the candidates get used to handling structural funds. Of the €4 billion allocated under the facility, the candidates had managed to spent only €200 million by the end of 2002. One of the problems is that the candidates simply cannot find enough viable projects (the value of each project is supposed to exceed €5 million, which is a substantial amount in small transition countries). Another is the requirement that 25 percent of each project has to be cofinanced out of national or regional budgets. Cofinancing requirements under structural fund rules can be lower, 15 to 20 percent, but they will be an additional burden on already stretched government budgets. The Commission has tried to alleviate these problems by paying out a larger share of money through the cohesion funds, which pay for straightforward infrastructure or environmental problems and do not have cofinancing requirements; nevertheless, EU aid inflows are likely be a trickle rather than a flood in the first couple of years after accession.

The real impact of the structural funds is therefore likely to come during the next EU budget period, which will run from 2007 to 2013. How much money the new members will receive during that period will be decided in forthcoming budget negotiations. With the accession of the East Europeans, average EU GDP will drop by about 10 percentage points. This means that many of the regions that currently have GDP per head less than 75 percent of the EU average, and so qualify for regional support, will no longer do so. As a result, all Germany’s new states, all but two Spanish regions, and all but one region in Italy will no longer qualify for Objective 1 funding. In addition, GDP per head in Spain will move above 90 percent of the EU average, which means that it will no longer qualify for cohesion fund money. Even though economic growth means that around a quarter of the regions now covered by Objective 1 funding would lose their entitlement even if enlargement did not take place, Italy, Spain, and other countries are still likely to fight to retain their entitlements in the EU budget.

Estimates by PNB Paribas, a French bank, show that if current rules were maintained, the costs of Objective 1 support (including pre-accession aid) would rise from €165 billion in 2000-06 to €251 billion in 2007-13. The amount current EU members received would fall from €1,406 billion to €936 billion, and the sums the 12 newcomers received would rise from €25 billion to €157 billion. Only Greece and Portugal would still be eligible for cohesion fund money, and the new members could expect around €26 billion from this facility.

Uncertainty about the impact of structural funding on recipients’ growth rates is considerable. The sums dispensed through the EU’s structural funds budget have grown significantly over the past 20 years. EU regional aid has amounted to 1 to 3 percent of Portuguese and Spanish GDP in recent years, financing 5 to 10 percent of total investment and increasing the funds available for public spending (net of transfers and health and social insurance payments) by 10 to 20 percentage points. Most of the money from the structural funds is spent on physical infrastructure, such as roads or sewage systems, with much of the rest financing education and training.

The author is chief economist at the Center for European Reform, London. This article is excepted from "Will EU Money Help Eastern Europe to Catch Up?," published in the Economic Intelligence Unit’s Country Forecast, March 2003.