Back Matter

Back Matter

International Monetary Fund
Published Date:
April 2002
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    For a more detailed analysis of the Baltics’ transition years, see Berengaut and others (1998).

    At least according to official statistics. For a different interpretation of the initial output collapse, see Åslund (2001).

    The Laeken summit concluded that if the present rate of negotiations and reforms were maintained, the candidate countries would be ready to accede to the EU in 2004, in time for their participation in elections for the European Parliament in the that Of 2004.

    Under the 1992 Maastricht Treaty, the general government fiscal deficit should not exceed 3 percent of GDP and gross government debt 60 percent of GDP. These benchmarks could be exceeded if the excess deficit was small and either temporary or had declined significantly, and debt was on a clear downward path.

    The 1997 SGP requires members of the European Economic and Monetary Union (EMU) to achieve cyclically adjusted fiscal positions that are close to balance or in surplus, so that they can respect the 3 percent deficit ceiling during cyclical downturns. The sanctions part of the SGP applies only to countries that have adopted the euro.

    Estonia’s sovereign rating from Fitch-IBCA and Standard and Poor’s for long-term foreign currency debt is A-, whereas Latvia and Lithuania are rated BBB and BBB-, respectively.

    There is relatively little progrcssivily in the tax systems of the Baltics, since personal income is taxed at a single flat rate. What little progressivily there is comes largely through the personal income tax threshold, which is currently below the minimum wage.

    The analysis in the appendix suggests that the debt ceiling would not be reached for two decades, assuming that there is no increase in the real interest on public debt during that time. This assumption is unlikely given that in Latvia and Estonia, for example, the overall fiscal deficit would have reached 5 ¾ percent by the end of this period.

    Conversely, an imprudent fiscal policy stance could significantly raise interest costs and potentially lead to a liquidity problem for the budget if financing were to dry up.

    The key role for fiscal policy in the Baltics in this regard is as a tool to stabilize aggregate demand. In addition, fiscal policy must support the Baltic countries’ fixed exchange rate mechanisms; in this sense, fiscal policy also has an indirect role to play in maintaining stable and low inflation.

    Whether the 3 percent deficit ceiling under the Maastricht Treaty is sufficient to allow the lull operation of the automatic stabilizers in the Baltics depends on the choice of the medium-term fiscal target, as well as the amplitude of both the cycle and the stabilizers themselves. If GDP falls below its potential by 1 percent age point, fiscal deficits are estimated to increase by about ½ of 1 percentage point on average in EU countries (see European Commission. 2000). However, cyclical volatility could be expected to be larger than the EU average in the Baltic countries, given their characteristics as small open economies. Overall, it seems likely that aiming for a broadly balanced budget over the medium term or economic cycle would enable the Baltics to accommodate a substantial cyclical deterioration in the fiscal position while remaining within the Maastricht 3 percent deficit ceiling.

    The adopted target should be based on a comprehensive measure of the general government’s fiscal position. There could, however, be practical problems in adopting such a target, given the often limited control over local government budgets, and the existence of extrabudgetary funds.

    Such flexibility should, however, also be consistent with other objectives such as external and public debt sustainability. In this regard, it is worth noting that year-to-year departures from the cyclically adjusted fiscal target resulting from the operation of automatic stabilizers would be fully consistent with public and external debt sustainability, provided that the medium-term target is itself consistent with public and external debt sustainability and that the government’s commitment to the fiscal policy rule is fully credible.

    Sweden follows such an approach. An alternative would be to adopt an explicit target for the stock of debt relative to GDP.

    Such an approach was also used in Daseking and Christou (2002).

    Chalk and Hemming (2000) note that the condition of a non-increasing debt ratio, while intuitively appealing and useful for practical purposes, is not the same as the theoretical notion of fiscal sustainability. Fiscal sustainability attempts to determine whether current or alternative policies can be sustained over the long run and is derived in terms of the government’s present value budget constraint. However, as Blanchard, Chauraqul, and Hajeman (1990) note, the above condition is often used as a substitute for the present-value budget constraint.

    For a further discussion, see Boadway and Wildasin (1993). The relationship between debt and economic performance is also likely to vary across countries and from time to time.

    See, for example, Frankel and Rose (1996) and IMF (1998).

    Those forms of FDI that are debt creating should ideally be excluded. The analysis could be further refined by the inclusion on non-debt-creating flows of portfolio equity investment.

    As transition economies, the Baltics can be expected to run large current account deficits, as rapid productivity growth provides profitable investment opportunities in excess of domestic saving. Such foreign saving channeled into productive domestic investment also constitutes a key determinant of the speed of income convergence with advanced economies.

    For further information, see Georgakopoulos (1994) on Greece; O’Donnell (1991) Ireland; Ordaz (1993) on Portugal; and Utrilla de la Hoz (1993) on Spain.

    The agricultural sector in Lithuania is somewhat higher, accounting for 7 percent of GDP.

    The structural funds were introduced in stages since the Treaty of Rome to ameliorate social, agricultural, fisheries, and regional conditions. The Cohesion Fund was created with the European Single Market to reduce the income gap between the EACs and the rest of the EU. Countries with a per capita GNP below 90 percent of the EU average are eligible to draw from this fund.

    The surge in the Irish FDI is partly explained by a strengthening of data collection, which from 1998 onward also covered financial service activities, including those related to the International Financial Services Centre.

    For an in-depth look at the fiscal adjustment in Ireland, see Honohan (1999).

    Measured as the first difference of the ratio of per capita GDP of the EACs (on a PPP basis) to EU average per capita GDP (as shown in Figure 3).

    All variables were derived from the IMF’s International Financial Statistics (IFS) database, except for SIC,t which was based on data from the IMF’s World Economic Outlook database. Some observations in the early 1970s not available in the IFS were derived from IMF staff reports. Although it would be preferable to control also for the Maastricht Treaty and the SGP in equation (3), the timing of the required fiscal adjustment has been different for each EAC; Greece, for example, only met the Maastricht criteria in 2000.

    For a similar conclusion based on qualitative evidence, see World Bank (2002).

    Of the three countries that joined NATO in 1999 (the Czech Republic, Poland, and Hungary), only the first two met the military spending target of 2 percent of GDP at the time of accession; Hungary’s defense expenditure was only about 1 percent of GDP.

    Under the 2001 national budgets, military spending amounts to 1.8 percent of GDP in Estonia, 1.3 percent of GDP in Latvia, and 2 percent of GDP in Lithuania. Latvia aims to raise military spending to 2 percent of GDP by 2003, and Estonia expects to do so by 2002.

    A nonnegligible part of spending that will be supported from the EU is likely to represent a continuation of existing programs. For example, investment in road infrastructure is likely to be undertaken by the national authorities irrespective of EU accession. As a result, the extent of the slowdown in the real increase in non-priority spending in all three scenarios could be overstated. To address this problem, a range is provided in the tables, with the lower end represented by the assumption that half of EU financial assistance and cofinancing would finance existing programs.

    Given the scope of the task, it is assumed that overall fiscal balance would be achieved by 2006 only; in Lithuania, this is assumed to be achieved excluding the costs of pension reform (about ½ of 1 percent of GDP), in contrast to the other two countries. All three countries would have a fiscal deficit below 1 percent of GDP by 2004, the assumed accession year. This translates into a primary surplus beginning that year at the latest.

    Such estimates, including those on the split between the various instruments, are largely based on information from the EU and a study on Lithuania, prepared by Finnish experts in 2000 (PHARE-Project LI/EI 9701, “Support to European Integration in Lithuania (SEIL),” Final Report of the Sub-Project Support for Policy Impact Analysis/Budgetary Impact, Helsinki, August 2000).

    For example, in Latvia, it is projected that the corporate income tax is reduced in three steps from the current rate of 25 percent to 15 percent. At the same time, some tax exemptions under the corporate income tax law and the foreign investment law are being phased out. The scenario also reflects a lowering of the social tax rate from 35 percent in 2001 to 31 percent by 2006.

    The different real spending growth rates across countries largely reflect differing assumptions for nominal GDP growth and inflation, especially in the early years. For example, consumer price inflation is higher in Estonia than in Latvia and Lithuania, especially in 2001, reflecting Estonia’s peg to the euro. This reduces real spending growth in Estonia relative to Latvia despite similarities in the level of necessary cuts relative to GDP. The relatively low growth in nominal and real GDP in Lithuania leads to tower real spending increases than in the other two cases.

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