IV What Do the CECs Bring to Euro Adoption?

International Monetary Fund
Published Date:
April 2005
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Accession to the EU and conforming to the acquis communautaire will result in a marked convergence of the CECs’ legal, administrative, and infrastructural attributes to those of the EU. But the quite different economic histories of the two groups leave substantial gaps in fundamental economic characteristics that will shape the CECs’ experience within or outside the euro area for some time to come. Because these will be fundamental to the analysis throughout this study, this section identifies some defining characteristics of the CECs that will influence decisions on entry to—and their eventual experience in—the euro area.

Income Gap

The income gap vis-à-vis the euro area is large but shrinking. Per capita GDP at PPP exchange rates in the CECs is just under 50 percent of that in the euro area. Ranging from 40 percent of the euro-area level in Poland to over 70 percent in Slovenia, GDP per capita in each country except Slovenia is below that of the poorest euro-area member. Convergence over the past five years has been modest: annual growth of per capita GDP in the CECs has exceeded that in the euro area by an unweighted average of 1.3 percentage points (Figure 4.1; this and subsequent figures are grouped at the end of Section IV).

Figure 4.1.CECs: Income Gaps

(GDP per inhabitant at PPP exchange rates; in percent of euro area)

Economic Size

In economic terms, the CECs will be a small addition to the euro area. Two measures of economic size indicative of the potential impact of euro adoption by the CECs on the euro area leave little doubt that the impact will be small (see Figure 4.2). Total GDP of the CECs at PPP exchange rates amounted to only 10 percent of that in the euro area during 2000–02, and broad money in the CECs to even a smaller share of total euro-area M3. The share of CECs in total euro-area population is larger, though still only about 20 percent. If per capita incomes were to catch up to the euro-area average within 25–30 years, United Nations Development Program (UNDP) projections of population growth suggest that the share of CEC GDP in the enlarged euro-area GDP would be about 21 percent.

Figure 4.2.CECs: Selected Indicators of Size1

(Average of 2000–02; in percent)

Sources: Eurostat; OECD; and country authorities.

1 Sum of the CECs relative to the euro-area total.

Capital-Labor Ratios

The CECs are capital-poor and labor-rich compared with the euro area. Average capital-labor ratios in the CECs are substantially below those in the advanced euro-area countries, despite the fact that employment ratios are generally also lower (Figures 4.3 and 4.4). The scarcity of physical capital, together with reasonably strong endowments of human capital, suggests that the marginal product of capital is relatively high in the CECs. Provided that the large differences in output per worker reflect differences in capital-labor ratios rather than inherently low total factor productivity (TFP) owing to institutional or technology differentials, the profitability of investment in the CECs should be substantially higher than in advanced euro-area countries. This should constitute a strong attraction to foreign capital.

Figure 4.3.CECs: Estimates of Capital per Worker Relative to Germany1

(Average of 1997–2002; in percent)

Sources: Eurostat; Polish Central Statistical Office; and Lipschitz, Lane, and Moumouras (2004).

1 Estimates for 1999 assume total factor productivity across countries is identical to that of Germany.

Figure 4.4.Employment in Percent of Working-Age Population

Source: Eurostat.

Capital Inflows

Capital inflows are large, volatile, and virtually free of controls. On average, the CECs had net capital inflows (including errors and omissions) equivalent to 7.2 percent of GDP during 2000–03 (Figure 4.5). Although the composition of inflows varied widely across countries, for most CECs FDI accounted for at least 75 percent of the total, the exception being Slovenia (40 percent). But inflows were volatile. Over the past decade, the standard deviation of annual net inflows ranged from 59 percent of the average euro-area level in Poland to 84 percent in Slovenia. The great majority of controls on capital flows have been eliminated to conform to certain CEC commitments to the OECD and EU. Remaining restrictions in individual countries are mainly related to certain CEC investments in foreign assets, and the acquisition of real estate by foreigners and proscriptions on FDI in some sectors.

Figure 4.5.CECs:Total Net Capital Inflows

(Average of 2000–03; in percent of GDP)

Sources: IMF, World Economic Outlook; and Slovenian authorities.


Investment in the CECs is high compared with the euro area. Underpinning large current account deficits in most CECs are investment rates that substantially exceed, and savings rates that slightly exceed, those in the euro area (Figure 4.6). In part this reflects relatively high public investment and low or negative public saving, but private investment and saving rates also stand apart from the euro-area average in most CECs.

Figure 4.6.CECs and Selected Noncore Euro-Area Countries: Current Account Deficits, Investment, and Savings

(In percent of GDP)

Sources: IMF, World Economic Outlook; and IMF staff estimates.

1 Positive numbers indicate deficits.

2 CECs—average of 2000–03; noncore euro area—average of 1995–98.

Real Appreciations

Real appreciations have generally been sizable (Figure 4.7). This reflects, at least partly, B-S effects—faster productivity growth in the tradables than in the nontradables sector that forces nontradable prices to rise faster than tradable prices (Appendix 4.1). Estimates of B-S-induced change in the domestic price of nontradables relative to tradables in the transition countries average about 3 percent a year over the past 5–10 years, with considerable variation across countries (Begg and others, 2003; and Cipriani, 2000). The contribution of B-S effects to equilibrium CPI-based real appreciations, which depends inter alia on the size of sectoral productivity gains in the transition country relative to those in other countries, is estimated at 1–2 percent per year relative to Germany (Kovacs, 2002). CPI-based real appreciations caused by faster productivity growth in the tradables sector do not reflect an erosion in external competitiveness because they are consistent with unchanged labor-cost-based measures of the real exchange rate. However, actual CPI-based real appreciations during 1996–2003 generally exceeded the estimated contribution of B-S effects, suggesting that other influences are at play or that some overshooting of equilibria has occurred (Table 4.1). Other possible influences include catch-up from previous undervaluation, deregulation and price liberalization (affecting mainly nontradables), increases in indirect taxes, and demand-induced increases in nontradables prices owing to growing real incomes.

Figure 4.7.CECs: Real Exchange Rates and Their Components

(2003 Q4 = 100)

Sources: IMF, International Financial Statistics; and IMF staff calculations.

1 ULC, unit labor cost.

Table 4.1.CPI-Based Real Appreciation and Estimated Contribution of the B-S Effect for the 1990s1(Annual average, in percent)
Estimated Contribution of B-S Effects2Actual (1996–2003)
Czech Republic1.65.6
Slovak Republic1.0–2.06.2
Sources: Kovacs (2002); and IMF staff calculations.

Relative to Germany.

Estimated by Kovacs (2002).

Sources: Kovacs (2002); and IMF staff calculations.

Relative to Germany.

Estimated by Kovacs (2002).


Notwithstanding B-S effects, inflation has fallen. In some of the CECs, the drop has been to low levels even by euro-area standards (Figure 4.8). In the lowest-inflation countries—the Czech Republic and Poland—conjunctural macroeconomic developments and current or recent sharp nominal appreciations contributed. In other countries, somewhat higher inflation reflects a variety of influences: larger increases in unit labor costs (ULC) (Hungary and Slovenia); nominal depreciations (Slovenia) or muted nominal appreciations (Hungary and Slovak Republic); and recent indirect tax and administered price changes (Slovak Republic).

Figure 4.8.CECs: Consumer Price Index

(Percent change, period average)

Sources: IMF, International Financial Statistics; and IMF staff estimates.

Financial Sectors

Financial sectors are small, dominated by foreign banks, and reasonably well-supervised. By any measure of money or credit aggregate, CEC financial sectors are small (Figure 4.9). The largest gap vis-àvis the euro area is in bank credit to the private sector, although it is growing rapidly in all countries except Slovenia. Banks—in all countries except Slovenia, foreign-owned banks—dominate the provision of financial services, holding 75–90 percent of total assets of financial institutions compared with 70 percent in the euro area. Bond market capitalization—primarily government bonds—is about 30 percent of GDP on average, compared with 130 percent of GDP in the euro area, and equity markets are still small. Derivative markets are at an early stage of development: bond and equity derivatives account for only 1–2 percent of market capitalization of the underlying assets, in contrast to some Asian countries where derivatives are a multiple of market capitalization. Except for the Czech Republic and Poland, liquidity in the currency derivatives markets is also low. IMF–World Bank Financial Sector Assessment Programs (FSAPs) in each of the CECs found that regulatory and supervisory systems are moving toward international best practices, but areas for improvement remain—primarily in consolidated reporting and supervision, assessing credit risks, and, for Slovenia, regulating related-party lending.

Figure 4.9.CECs and Selected Euro-Area Countries: Measures of Size of Financial Markets

(In percent of GDP)

Sources: IMF, Money and Banking Database; Eurostat; Bank for International Settlements; and IMF staff calculations.

1 Data for Slovak Republic and Slovenia not available.

Fiscal Deficits

Fiscal deficits are generally large, while future demographic pressures differ. In 2003, general government deficits in all the CECs except Slovenia were well above 3 percent of GDP, although government debt ratios are generally below 60 percent of GDP (Figure 4.10). In general, large deficits reflect high structural expenditures (particularly in the social sphere) although, with output gaps estimated to be negative in all the countries, cyclical influences are also at play. Expected demographic trends will add to fiscal pressures to varying degrees: the expected increase in the dependency ratio in Slovenia exceeds that in the EU, while in Poland and the Slovak Republic aging pressures are more moderate (see the bottom panel of Figure 4.10).

Figure 4.10.CECs and the European Union: Fiscal Positions and Demographics, 2003

Sources: IMF, World Economic Outlook; and country authorities (Pre-Accession Economic Programs);World Bank, Development Indicators 2000; Dang, Antolin, and Oxley, “Fiscal Implications of Ageing: Projections of Age-Related Spending,” OECD Working Paper No. 305, 2001; for Slovak Republic and Slovenia: UN World Population Prospects, 2002.

1 Factors underlying the significant differences between the GFS and ESA-95 data include different treatment of government guarantees and second-pillar pension system holdings of government debt.

2 For Poland, ESA-95 including second-pillar pension funds in the general government.

3 For Czech Republic, ESA-95 deficit and debt exclude government guarantees that have not been called.

4 Population over 65 years as a ratio of the working-age population (20–64 years).

5 Excluding Greece and Ireland.


Unemployment rates vary widely in moderately flexible labor markets. Unemployment rates range from about 6 percent to almost 20 percent, reflecting widely varying labor force participation rates, burdens from restructuring, and cyclical influences. Problems with skill mismatches are evident in the high rates of long-term unemployed compared with the euro area (Table 4.2). Labor market flexibility, as measured by the strictness of employment protection legislation, is better than in most euro-area countries, but not as strong as in Ireland or the United Kingdom.

Table 4.2.Labor Market Characteristics1
EU-15Czech RepublicHungaryPoland2SloveniaSlovak Republic
Total unemployment rate (in percent of labor force)
Unemployment by duration (in percent of total unemployment)
Less than 6 months42.227.831.624.227.215.8
6 to 11 months17.621.723.621.418.218.9
12 months and more40.250.544.854.454.765.3
Employment protection legislation42.
Source: Eurostat; OECD; and Slovenian authorities.

Labor force survey basis, 2002.

Covers population aged 15 and above.

25–64 years.

Indicators range from 0 to 6, with a higher number indicating stricter employment protection.

Calculated by the Slovenian authorities.

Source: Eurostat; OECD; and Slovenian authorities.

Labor force survey basis, 2002.

Covers population aged 15 and above.

25–64 years.

Indicators range from 0 to 6, with a higher number indicating stricter employment protection.

Calculated by the Slovenian authorities.

Appendix 4.1. Measuring Balassa-Samuelson Effects

The B-S-induced change in the relative price of nontradables can be written as:

where p, pT, pNT are the logs of the level of aggregate, tradables, and nontradables prices, respectively; aT and aNT are the logs of total factor productivity (TFP) in the traded and nontraded sectors, respectively; δ and γ are the output elasticities of labor (assuming Cobb-Douglas technologies) in the nontraded and traded goods sectors, respectively; and C is a constant. The B-S contribution to domestic inflation can be written as:

Δp = ΔpT + αΔRER,

where α is the share of nontradables in the consumption basket. Assuming that the law of one price holds for traded goods, the cross-country difference in inflation due to B-S effects can be expressed as:

where * denotes variables of the foreign comparator country, and e denotes the nominal exchange rate expressed in units of domestic currency per unit of foreign currency.

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