Clift: You say that the road to EU accession is in many respects mapped out in advance for the applicant countries. In reality, how smooth is the process? What could go wrong?
Feldman: The road to EU accession and ultimately the adoption of the euro will place major demands on policymakers as they aim for low inflation, financial and macroeconomic stability, and continuing structural reform in economies increasingly open to capital inflows. It will also require skillful policy management to foster real convergence to EU income levels through growth that is not only strong but also sustainable. Thus, one of the challenges for the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia is to keep fiscal deficits within prudent limits and contain external current account deficits to avoid vulnerabilities. The good news is that an accession framework is in place, and, with the right policies, economic and monetary union and the full benefits of membership in the European Union are within reach.
Clift: To set this in a broader context, how large has the transformation over the past 10 years been, and what are the key issues in the next year or so for the Baltic countries?
Mueller: Estonia, Latvia, and Lithuania have done a tremendous job of moving from centrally planned economies toward full-fledged market economies. They have achieved substantial macroeconomic stabilization, sustained very high growth rates, and controlled inflation, which is now approaching the EU average. In addition, they have implemented a vast array of structural reforms to modernize their economies. Now the Baltics have to face new challenges, many of them on the fiscal side, which is the focus of our paper.
Clift: Max, how complicated is it for these applicant countries to adopt the euro, given the large and possibly volatile capital flows that may affect this process, and when might they do so?
Watson: Adoption of the euro is definitely a second phase, and there are several things to consider. One is the extent to which major structural changes may still be going on in these economies—something that varies from country to country. Another is the speed with which you want to reduce inflation. Everyone would agree that you want inflation in low single digits. How fast do you want to get it down to below 2 percent—which is the euro-area goal—when you have all sorts of other changes in relative prices going on?
A third factor is the maturity of the financial sector. A number of the EU accession countries—certainly some in central Europe—have made remarkable strides in modernizing their banking systems, getting hard budget constraints in place, laying the basis for a sound transmission mechanism for monetary policy, helping to develop the private sector, and filtering capital inflows. Indeed, contrary to views sometimes expressed, the capital inflows and outflows will not be managed simply by adopting the euro: it depends on a range of policies and institutions, including a healthy financial sector—one that is skilled in managing market and credit risks. But most people would accept that—even in the most advanced cases—this process of financial sector maturation is not yet complete.
Clift: So the adoption of the euro is some way off?
Watson: The issue is not so much when it will happen as how: the precise timing should depend on each country’s situation and the progress made in the areas I just mentioned. Candidates must first pass through ERM2—the phase of economic and monetary union that involves a central parity and a wide band—so, yes, adoption would lie some years in the future.
Feldman: With yesterday’s transition economies becoming today’s emerging markets, which in turn are progressing from emerging to converging status, it is important to recognize, and minimize, the risks associated with prospectively large and potentially volatile capital inflows. In this context, the importance of a healthy financial sector cannot be overemphasized.
Clift: Given that it’s only about a decade since the Baltics gained independence, is there a danger of things moving too fast? Are they coping well?
Beddies: So far, the Baltic countries are coping extremely well with the challenges they have been facing. It is important to note that stabilization in the Baltics was achieved through currency boards in Estonia and Lithuania and a fixed exchange rate regime in Latvia. These hard pegs were extremely successful in instilling stability and credibility in the monetary sphere and should continue to serve the Baltics well in their transition toward EU membership. But on the fiscal side, they will have to make some politically difficult choices. The transition phase to EU membership for these countries is much shorter than for previous accession countries. Nevertheless, the Baltics start in a fairly good fiscal position, so they are well placed to meet these challenges.
Clift: What are these politically difficult choices that the Baltics face?
Beddies: Choices about maintaining or achieving budget balance over the medium term.
Mueller: Tough choices on the expenditure side of the budget; EU accession requires certain spending based on commitments that are currently being negotiated. But if at the same time the countries are moving toward a balanced budget and thinking about lowering the tax burden, something has to give, and that something is discretionary, nonpriority spending.
Clift: So you foresee considerable fiscal tensions?
Feldman: One thing that emerges from our study is that fiscal policy has a lot to contend with. It is at the fulcrum of policy frameworks. It has to deal with various economic stresses, including those that can arise, for example, from current account deficits or the difficulties in macroeconomic management in the face of large and potentially volatile capital inflows. It is also faced with various competing spending pressures that tend to add to the fiscal deficit at a time when countries are rightly seeking to consolidate their public finances over the medium term. But uncertainties in the economic outlook should prompt, not discourage, a medium-term approach to policy.
Watson: The policy frameworks present a fundamental dilemma for policymakers. Policies need to be firm enough to both guide and harness expectations, but flexible enough to cope with uncertainty in the real economy and about prices, capital flows, and the current account of the balance of payments. How does one achieve this? Policy frameworks must be credible and transparent so that uncertainties can be handled. And such frameworks must be cast in a medium-term mold, as Bob said.
Feldman: Medium-term fiscal frameworks also help identify, early on, the tensions that can arise and allow the authorities to determine how best to phase in needed structural reforms. This includes upfront expenditure reforms that are so important if lower-priority, discretionary spending items are to adjust to achieve targets for the fiscal balance while safeguarding high-priority expenditures that support growth. In this context, medium-term expenditure limits are also an attractive tool for establishing credibility and political support.
Mueller: Our paper has also focused on the need to have medium-term frameworks in place to help set spending priorities. We mention the importance of public sector reform—to help improve the efficiency and effectiveness of public sector spending—and pension and civil service reform. While the central European study favors expenditure rules, our paper promotes a balanced budget rule that could offer some policy guidance for the Baltic countries. But it doesn’t really matter which rule they follow, as long as the role helps shape expectations, is transparent and credible, and can be monitored.
Clift: You indicate that the Baltic countries need to increase military spending. How will that be achieved?
Beddies: We were talking about the commitments the authorities have already made. They have strong hopes of joining NATO [the North Atlantic Treaty Organization] and are committed to meeting its requirements, which would mean spending roughly 2 percent of GDP on military expenditures by the time they accede to the treaty.
Mueller: And the Baltics have almost achieved these targets. Estonia and Lithuania are already at 2 percent of GDP, and Latvia is at 1.8 percent of GDP.
Beddies: Latvia will achieve it next year.
Watson: Should these countries be trying urgently to meet the Maastricht fiscal criterion or to conform with the EU Stability and Growth Pact? In other words, should they aim now for fiscal positions that are limited to a deficit of 3 percent of GDP or set their sights on positions that are close to balance or in surplus?
Both of our publications suggest the initial emphasis should be on fundamentals. And what the fundamentals suggest for the small and very open Baltic economies is a balanced budget rule, provided that it fits broadly with the external current account framework. In the central European economies, our answer is to develop a rule rooted in the fundamentals of each of these economies. There is a big difference, for example, between Poland and Estonia. Again, we say: don’t meet Maastricht too early, simply for Maastricht’s sake—look at the fiscal position in terms of domestic priorities, including sustaining growth.
This suggests that the larger countries in central Europe should not focus on a balanced budget rule but pay attention chiefly to the external current account deficit and not let it get too big. Empirically, this advice likely drives one toward fiscal positions that are fairly close to balance—in fact, Maastricht compatible, but for domestic and fundamental reasons, not doctrinal. A fairly prudent fiscal policy clearly supports sustainable growth. There is no conflict between sound fiscal positions and real convergence.
Mueller: We fully agree. For the Baltics, there are some key reasons why they should adhere to their self-declared balanced budget objective. First, given the exchange rate pegs, fiscal policy is the sole macroeconomic policy instrument to limit the risks emanating from persistent external current account deficits. Second, the public sector’s call on national saving must be reduced to maintain low interest rates and avoid crowding out the private sector. And, third, the authorities must avoid a situation in which they have to undertake a procyclical fiscal adjustment to meet the Maastricht and Stability and Growth Pact criteria.
Clift: What does the accession of all these applicants mean for the current European Union?
Watson: On the EU side, there is a question of further improving the efficiency and design of some institutions as you expand the membership. That is an institutional challenge, but we all know that it has a political dimension. It is not easy, but I’m sure it will be accomplished.
Another concern is an inflow of labor from central and eastern Europe, or pressure on wages to become more differentiated. The message for policymakers in existing EU member states is to press on with the structural reforms you need to make anyway. These will tend to enhance the functioning of their labor markets and draw more people into employment, including through further liberalization and wage differentiation, where needed. As those things go right within the European Union, they will intrinsically allay some of the concerns about enlargement. Therefore, there is no conflict between the domestic EU priorities in structural policies and the requirements of accession. Far from it. This should be a virtuous circle. With the right policy setting, it is a win-win situation. But from the political economic perspective, we know structural reform is not easy.
Feldman: Indeed. The past 10 years have been historic in terms of the breakdown of central planning, the move to market economies, and now the efforts to join the European Union. The candidate countries benefit, but so, too, do the existing members. As Max said, it is really a win-win situation. As a result, we look for a larger economic and monetary union that will bring benefits to everybody involved.
Copies of IMF Occasional Paper No. 213, The Baltic Countries: Medium-Term Fiscal Issues Related to EU and NATO Accession, by Johannes Mueller, Christian Beddies, Robert Burgess, Vitali Kramarenko, and Joannes Mongardini, are priced at $20.00 ($17.50 for academics and students).
Into the EU: Policy Frameworks in Central Europe, by a staff team led by Robert A. Feldman and C. Maxwell Watson, with Peter Doyle, Costas Christou, Christina Daseking, Dora Iakova, Guorong Jiang, Louis Kuijs, Rachel van Elkan, and Nancy Wagner, is available for $26.00 from IMF Publication Services. See page 167 for ordering information.