Stability and Growth in EU Accession Countries
by Laszlo Halpern

As the EU membership of eight transition economies draws close, new research is drawing attention to the new members’ complicated task of meeting the Maastricht requirements. Not only do they have to pursue stability-oriented macroeconomic policy, but they also have to try to catch up with the more developed member states. This implies that figures on the new members’ inflation, public debt, current account deficit, and so on should be evaluated using different conditions than those applied to current EU members.

The eight new Central European and Baltic member states of the EU—the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia—are required to pursue stability-oriented policies. If they are unable to meet the criteria of the Growth and Stability Pact (GSP), that is, the Maastricht Treaty, these countries will be subject to the excessive deficit procedure. This procedure authorizes the European Commission, the EU’s executive arm, to take draconian measures in relation to any state that threatens the integrity of the monetary union by pursuing inflationary policies until it lowers both its budget deficit and its inflation rate. For example, the French budget presented in late September 2003 foresees a 2004 public deficit of 3.6 percent of GDP, the third year in succession that France will have exceeded the limit set out in the GSP. Enforcement of the excessive deficit procedure could ultimately lead to the imposition of heavy fines if other member states agree. The new members—all of them firmly committed to introducing the euro—must make extra efforts to meet the Maastricht requirements because they are not just pursuing stability-oriented macroeconomic policy, but also trying to catch up with the more developed member states.

These catch-up economies have already achieved a high degree of integration with the EU-15. During the transition period they transformed their production and trade patterns by reorienting themselves toward Western markets and by attracting large amounts of foreign capital. Thus the business cycle in these countries has become strongly synchronized with the EU and with the euro zone. Whether the criteria and the procedures for ensuring macroeconomic stability in the EU will be appropriate for promoting dynamic growth and increasing welfare in the enlarged EU remains an open question, however.

Equal Treatment

Equal treatment of member states is a core principle of European integration. It entails the following three major requirements for euro zone membership:

• Legality: no retrospective changes of exchange rate rules

• Fairness: the same treatment is to be applied to both new euro zone candidates and old euro zone members

• Economic rationality: stability and growth should be maintained as determined in the GSP.

However, this core principle, or rather its mechanical interpretation, is entailing some disadvantages for the new members. The required price stability is a good example. The real exchange rates of currencies in the new member states are expected to appreciate over the long run as a result of their productivity advantage in the tradables and service sectors compared with that of their trading partners (known as the Balassa–Samuelson effect). The trend of real appreciation implies that at a constant exchange rate the new members’ equilibrium inflation will be higher than that defined as price stability for the European Monetary Union. Pushing inflation below the rate that is required by Maastricht inflation criterion (see the box) could result in unnecessary output losses.

The equilibrium real interest rate in the new member states is expected to fall. The risk premium on assets denominated in domestic currency is reduced by entry into the European Monetary Union. Lowering interest rates stimulates private sector spending and could increase private debt and external imbalances.

Any shock to the external balance spills over to inflationary expectations. The market is aware that debt crises can be solved either by recession, by depreciation accompanied by inflation, or by both. As the catch-up countries are exposed to a high risk of external balance, they also bear a high inflation risk. Policies that aim at minimizing inflation risk have to minimize external balance risks at the same time.

Capital Flows: Blessing and Curse

Most new member states are small, open economies that are excessively sensitive to changes in exchange rates. They face intensive and fluctuating capital flows as they have already fully liberalized their capital markets, a precondition for EU entry. Globalization has had a clear, positive effect, because foreign investment is necessary for financing the catch-up process, but it makes currencies more vulnerable. The prospect of EU enlargement itself attracts capital flows, but short-term and volatile movements can endanger catching up with speculative attacks and monetary instability.

Thus capital flows could significantly constrain elbow room for an independent monetary policy. Exchange rates may easily deviate from the equilibrium path under the pressure of capital flows, influenced by factors that are beyond the control of domestic economic policy. Countries that offer both relatively high real interest rates and the prospect of steady real appreciation are likely to attract substantial speculative capital inflows.

The resulting overappreciation of the candidate countries’ currencies might be even more harmful than an eventual undervaluation. The real appreciation effect of an interest rate hike hurts primarily the tradable sector’s competitiveness. Relative prices become distorted, running the risk of a long-lasting disequilibrium. Emerging high external deficits might exceed the limit determined by policy credibility. Hence capital is needed for catching up, but large exchange rate movements induce unhealthy and costly fluctuations that can delay the process for a long time.

The new member states’ public indebtedness is well below EU-15 and EU-12 averages. None of them are heavily indebted, with debt to GDP ratios below 60 percent in all the countries, with Hungary having the highest debt level at 56 percent. Member countries with a debt to GDP ratio "well below" 60 percent are allowed to deviate temporarily from the medium-term target of zero-budget or a slight surplus, but they should be committed to fiscal reforms. They are authorized to run small, temporary budget deficits if structural reforms require additional financing.

Finding the Equilibrium Growth Path

The acceding countries need large-scale public investment (primarily in the area of infrastructure and the environment) to support private sector expansion and competitiveness. The demand for public investment might exceed the level that is offered by the new version of the GSP. The equilibrium characteristics of new members maintaining a dynamic growth path in the early phase would allow them to run even relatively high structural budget deficits without endangering fiscal discipline over the long run. Assuming 4 percent potential growth and 3 percent structural inflation, a catch-up economy with a 50 percent debt to GDP ratio can reduce its debt to below 30 percent in the long run by running a 2 percent structural budget deficit, especially if excess expenditures finance growth-supportive investments.

At the same time, however, the private sector’s growing need to borrow and the vulnerability of currencies could activate the constraint intended to safeguard current account sustainability. Even though the current account deficit ceiling that foreign investors are willing to finance could be significantly pushed up—one major advantage of EU membership—the volatility of capital flows warns domestic policymakers that exchange rate risks are not negligible. Therefore once growth resumes, they should go ahead with fiscal adjustment (independent of the Maastricht criteria) just to keep the catch-up process within a manageable margin.

Along the equilibrium growth path the new member states can run medium-term structural deficits, at least in the initial phase of catching up. The faster they grow, the greater the probability that they will meet the 3 percent deficit criterion. To avoid excessive external financing and/or inflationary pressure they will have to react to private sector expansion by cutting the public deficit (sometimes achieving budget surplus). Sustainability of the current account remains the number one financial constraint in the run-up period.

The recent reinterpretation of the GSP whereby it gives more flexibility to fiscal policy if public debt is low is a first step in the right direction. However, as a firm theoretical underpinning for what constitutes an optimal level of public debt is not available, particularly given that budgets may have very different tasks in different phases of development, meeting the GSP criteria is likely to cause even more trouble in the enlarged EU than before enlargement. Excessively tight fiscal control in the euro zone might increase adjustment costs, especially in cyclical downturns and in the new member states, because fiscal policy is the tool for responding to country-specific developments and shocks.

Lászlo Halpern is deputy director and senior research fellow at the Institute of Economics of the Hungarian Academy of Sciences. This article is based on work presented at the European Economics Association conference in Stockholm in August 2003. j