Chapter

4. Cross-Border Labor Flows in New Member States: Patterns and Challenges

Author(s):
International Monetary Fund. European Dept.
Published Date:
October 2008
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The flows of labor across the borders of the European Union’s New Member States (NMS) have not only intensified significantly since the onset of transition, but have also become increasingly diverse and flexible. Cross-border labor mobility has been beneficial to the NMS, speeding up the convergence process in countries where these flows have been large. Contrary to perceptions, labor mobility is an unlikely source of overheating; instead, it tends to play a cushioning role over the business cycle. In the medium term, however, outward labor mobility may contribute to wage increases that could combine with other rigidities and set off second-round inflationary effects. These need to be kept in check to preserve competitiveness. Better mobilization and utilization of labor are also desirable, to meet the challenges of reversing current account imbalances and ensuring sustained growth in the long run.

Overview

Along with the international flow of capital, the movement of labor across the borders of the European Union’s NMS has been a key feature in their process of income convergence.42 With the progressive relaxation of restrictions to the cross-border mobility of labor, most NMS have since the onset of transition experienced an intensification of the flow of labor across borders. These flows have manifested themselves in various guises and directions:

  • Over the past decade or so, many countries have experienced a wider variety in the way labor services are being provided across borders, whether through physical migration, change of permanent residence, and participation in the foreign labor market, or through various types of seasonal, temporary, or irregular flows of labor services across borders. These different modes have emerged in response to factors such as an increased availability of (very) low-cost transportation options, a less restrictive policy environment, and an increased demand for flexible forms of foreign labor.

  • Unlike capital flows—which have been primarily inbound—many countries have experienced flows of labor in both inbound and outbound directions. While several countries have witnessed sizable outflows to higher-income countries, many of them have simultaneously benefited from sizable inflows from their lower-income neighbors. In net terms, however, most countries have experienced large outflows for some time since the onset of transition.

The magnitude of these flows has fueled a debate that has unevenly emphasized the perspective of higher-income recipient or destination countries. For these countries, a key issue has been the absorption of foreign labor inflows in domestic labor markets. Whereas initially the concern was that large inflows would hurt labor market outcomes, the evidence thus far suggests that the inflows have been absorbed well. They have supplemented rather than replaced domestic labor, and, by doing so, they have alleviated aging-related problems, contributed to economic growth, and helped fend off inflationary pressures.43

Adopting the perspective of the NMS, this chapter documents the evolving patterns of cross-border labor mobility and addresses how the NMS can best manage the associated challenges. Building on a general equilibrium theoretical framework, this chapter discusses how labor mobility interacts with the process of income convergence. Among its key findings are the following:

  • Labor mobility speeds up the convergence process, helps boost economy-wide capital-labor ratios, supports aggregate demand through remittances, and may contribute to skills augmentation through the reintegration of returning migrants into domestic labor markets.

  • As labor migrates, so does part of the demand for nontradable goods. This migration moderates the boom in nontradable prices and the buildup of the current account deficit that arise during the convergence process. It also lessens the requirement for internal factor market flexibility to direct resources to the tradable sector, which would help reduce the current account deficit subsequently.

  • Restricting labor mobility is therefore no answer to overheating pressures. Labor mobility is unlikely to be a significant primary source of overheating. In addition, labor mobility tends to play a cushioning rather than amplifying role. However, over the medium term, second-round effects of wage inflation possibly associated with outward labor flows need to be avoided to prevent an erosion of competitiveness.

  • To ensure sustained growth, labor needs to be mobilized and utilized better, including by fostering labor force participation. This outcome would help countries face the challenges of reorienting resources from the nontradable to the tradable sector, as well as address any mismatches resulting from the differences in the age and skills composition of labor outflows and inflows.

Patterns

A general caveat applies to the discussion that follows on general patterns in cross-border labor mobility. The measurement of labor flows across borders is subject to various data limitations (availability, timeliness, precision, and quality). For example, migration registration systems reliant on changes in permanent residency may underestimate flows when foreign workers maintain their residency status while working abroad. Also, population censuses and labor force surveys may not capture temporary and irregular flows. Moreover, workers’ registration and other administrative systems in recipient countries may produce double counting and suffer from cross-country comparability.44

Intensified Flows

Labor market openness has made large and rapid strides since the onset of transition. Before transition, the movement of labor was highly restricted by governments (in terms of volume and destination) and primarily took the shape of settlement and irregular migration. The fall of the Iron Curtain gave a significant impetus to migration and, thereby, the mobility of labor across borders. However, labor markets in destination countries were opened up only gradually. Given the large income differentials and the uncertainty surrounding the possible scale of migration, restrictions were initially in force, but these were gradually alleviated in the wake of the successive EU enlargements.

The intensification of cross-border labor flows is evident in the development of net migration rates (Table 8). The data on net migration, derived from population statistics and available for most countries over relatively long periods of time, suggest that several countries have experienced strongly negative net migration rates over extended periods of time (i.e., outflows dominating inflows). This was particularly so in the Baltics during the early years of transition (reflecting the return migration of ethnic groups). Bulgaria, Poland, and Romania also experienced high negative net migration rates. For other countries, such as the Czech Republic, Hungary, and Slovenia, the average migration balance was positive.

Table 8.New Member States: Net Migration Rates, 1992–2007(Percent)
1992–951996–992000–032004–07
Estonia-17.1-4.90.10.1
Latvia-11.6-3.0-1.3-0.5
Lithuania-6.5-6.1-2.1-2.1
Bulgaria-2.70.0-6.50.0
Slovenia-1.10.11.73.6
Romania-0.9-0.5-6.1-0.3
Poland-0.4-0.3-3.0-0.5
Slovak Republic0.30.3-0.90.8
Czech Republic0.91.00.04.2
Hungary1.71.71.11.7
Sources: Eurostat; and IMF staff calculations.

Considering the period following the first EU enlargement in 2004, the evidence available on gross emigration rates suggests the following patterns:

  • From the perspective of the EU-15 old member states, the stock of foreign residents from the NMS-8 has increased by about 200,000–250,000 a year since the first EU enlargement.45 This represents a cumulative 1.5 percent of source countries’ total population since 2004, with Latvia, Lithuania, and Poland experiencing higher-than-average gross emigration rates.46

  • Countries that opened up earlier were among the more popular destination countries (Figure 33). Ireland and the United Kingdom, which were among the first to lift restrictions, recorded large inflows, leading to well-established migration networks.47 Factors other than migration restrictions also played a role, such as language barriers, as countries with similarly liberal regimes (e.g., Denmark and Sweden) did not experience sharp rises in inflows.

  • Bulgaria and Romania became important source countries well before their accession in 2007 (Table 9). In response to the large inflows after the first EU enlargement, Ireland and the United Kingdom chose to restrict access to their labor markets from Bulgaria and Romania in 2007.48 The most attractive destination countries then became Italy and Spain.49

Figure 33.Residents from the NMS-8 in the EU-15, 2000–06 1/

(Thousands)

Source: Brücker (2007).

Note: Data compiled from various national population statistics and Eurostat labor force surveys.

1/ NMS-8 comprises the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovenia, and the Slovak Republic.

Table 9.Largest Source Countries for Immigration in OECD European Countries, 2000 and 2005(Thousands)
20002005
Morocco96Poland324
Ecuador96Romania202
Poland94Morocco128
Bulgaria81Bulgaria82
Turkey79Germany77
Romania76Ukraine70
United States64Turkey66
Germany61United Kingdom65
France60Russia54
Italy56France49
Source: OECD, International Migration Outlook (2007).

Growing Flexibility

The past decade has also seen a sea change in the ways labor services are being provided across borders, as flexible modes of service delivery became increasingly more common:

  • Flexible forms of labor mobility have thrived in response to (1) the seasonality of labor demand in destination countries, especially in the agriculture and construction sectors, and (2) the generally greater demand in these countries for flexible forms of labor, given domestic labor market rigidities. This situation has increased short-term and high-frequency labor flows.

  • Proximity and accessibility factors have played a critical role in the emergence of these more flexible modes of delivery. The importance of geographical proximity is well illustrated in the cross-border linkages between Germany and Poland (Figure 34). For areas farther apart, accessibility has improved, thanks to low-cost transportation. This has fostered temporary forms of labor mobility (for example, between the Baltics and Ireland).50

  • A significant part of short-term labor flows may consist of irregular flows. The commuting back and forth by foreign laborers is hard to capture in the data and may lead to an underestimation of actual flows. At the same time, an increase in official cross-border flows after the lifting of inflow restrictions may be illusory, if the increase reflects the formalization of existing employment.51

Figure 34.Germany: Seasonal Migratory Workers, 1995–2007

(Thousands)

Source: Bundesagentur für Arbeit.

Changes in Composition

Although net flows may be of primary concern when the macroeconomic impact of labor mobility is being examined, the composition of gross flows matters too. Even if gross inflows exactly match gross outflows, an impact may be felt, not only through transitional costs arising from labor movements but also through changes in the composition of the labor force.

Two dimensions of interest for the composition of flows are age and skill level:

  • The limited evidence available suggests that, in recent years, the age distribution has not been significantly affected by the migration of labor (Table 10). By and large, young people are highly represented in outflow statistics. Yet, at the same time, they are also highly represented in the inflows to these countries. For the 15–24-year age group, the net migration rate is lower than average in Latvia and Poland (net emigration) and in Lithuania and the Slovak Republic (net immigration). For the age group of 25–29 years, only in Lithuania and Romania is net emigration significantly higher than average.

  • It is not clear whether a similar conclusion holds for the distribution of skills. Data on skill levels are much harder to obtain. The partial evidence available for Estonia and Poland suggests that the skill levels of immigrants are generally lower than those of emigrants, even though the evidence for Poland also suggests that skill levels of recent emigrants are higher than those of emigrants in previous decades.52 This finding, however, may not apply to other countries, as indicators of educational attainment of the working-age population in the NMS suggest an improvement in recent years.53 So, if emigrants had high educational levels, their departure is unlikely to have significantly reduced the average skill level of the labor force.54

Table 10.New Member States: Net Migration Rates by Age Cohorts, 2004–06(Per thousands)
15–24

years
25–39

years
40–54

years
55–64

years
15–64

years
Bulgaria
Czech Republic54.72.30.43.3
Estonia000.2-0.10
Latvia-0.70.1-0.2-0.30.2
Lithuania0.4-10.613.112.82.8
Hungary2.82.41.11.41.9
Poland-0.7-0.4-0.4-0.1-0.4
Romania-0.3-1-0.2-0.1-0.5
Slovenia4.12.51.30.52.1
Slovak Republic0.30.60.60.50.5
Source: Schreiner (2008).

Impact of Labor Mobility on Convergence

Over the past decade, the NMS economies expanded strongly, with income levels converging at unprecedented speed to EU averages (Figure 35). The per capita income levels in the Baltic economies improved dramatically, rising from about 40 percent to 63 percent of the overall EU average over only eight years.55 Other countries, such as Hungary and Slovenia, converged more slowly, partly because of their stronger starting position.

Figure 35.New Member States: Income per Capita Relative to EU-27, 2000 and 2007

(Percent)

Sources: Eurostat; and IMF staff calculations.

Note: The index provides a measure of the GDP per capita in purchasing power standards relative to the EU-27 average, which is normalized to 100.

How has this convergence process been affected by the mobility of labor across borders? Before addressing this question, it is useful to consider the stylized example of an economy catching up to higher living standards when the only type of labor mobility allowed is that between the sectors of the economy. Thus, workers can shift between jobs in a country (“internal labor mobility”), but not between countries for employment in a similar job (“external labor mobility”). Afterward, the cases of both internal and external mobility will be considered.

Convergence with Only Internal Mobility

Consider an economy whose productivity improves, benefiting all sectors in the economy, but especially the tradable sector (Figure 36, panel “A”).56 The process of convergence when labor is externally immobile is described by two distinct stages: an expansion stage and a reorientation stage.57

  • The expansion stage features a boost in the demand for tradable and nontradable goods. Consumers, to be able to smooth their consumption in anticipation of higher permanent income, will borrow from abroad. To satisfy the increased demand for goods, tradable goods can be easily imported from abroad, but nontradable goods need to be produced locally. Because it takes time to produce nontradables, demand for nontradable goods initially exceeds supply, causing nontradable prices to appreciate.

  • The reorientation stage takes place as soon as capacity in the nontradable sector has caught up with demand. This catch-up results in a dampening of nontradable price pressure, and the moderation in the relative price of nontradables, if not reversal, will help direct resources back to the production of tradable goods. The change in the economy’s production structure will reduce the dependence of consumers on foreign borrowing and help service the stock of foreign liabilities.

The internal mobility of labor is a crucial factor in making sure that convergence proceeds smoothly. If internal mobility were to be constrained for some reason, the rapid buildup of foreign debt during the expansion stage would no longer be optimal. It would prove too costly during the reorientation stage to shift labor resources from one sector to another. When internal mobility is limited, it will therefore be optimal to slow the convergence process by reducing the upswing in the expansion stage and lessening the requirements for structural change in the reorientation stage.

Convergence with Internal and External Mobility

Capital-Labor Adjustment

Consider now the case in which, in the economy described above, labor can flow not only internally across sectors but also externally across borders. This kind of mobility will have several effects on the medium-term convergence process:

  • As NMS economies typically have too little capital and too much labor, the marginal return on capital (labor) is high (low). The search for the highest return, therefore, simultaneously produces capital inflows and, when external labor mobility is allowed, labor outflows (Figure 36, panel “B”). In this way, the NMS are able to achieve a more efficient economy-wide capital-labor ratio.

  • Because income levels can be boosted by providing labor services abroad, greater external labor mobility produces faster convergence in consumption and, therefore, welfare levels (Figure 36, panel “C”).

  • Convergence measured in terms of output per capita also speeds up. However, because the utilization of labor resources is partly diverted abroad, the domestic product of the source country will grow more slowly than in the case of less or no external mobility (Figure 36, panel “D”).

Figure 36.Simulated Developments in Productivity, Foreign Labor, Consumption, and Output

Source: IMF staff simulations.

Note: For simulation details, see Bems and Schellekens (forthcoming).

Expansion and Reorientation

As for the two stages of convergence, external labor mobility has the following impact on the domestic economy:

  • External labor mobility moderates the expansion stage boom and lessens the resource shift needed in the reorientation stage. As labor flows abroad, so does part of the demand for nontradable goods, easing the bottleneck in the nontradable sector. As a result, nontradable price inflation will be more modest, too (Figure 37, panel “A”). So, even if convergence in consumption is faster, the domestic nontradable boom will be more moderate since economies abroad carry part of the burden of providing nontradable goods.

  • Since the expansion boom is moderated, the nontradable sector will expand less and more gradually, and the current account deficit will be narrower (Figure 37, panel “B”). This reduces the need in the next stage to reorient the economy toward the tradable sector. Interestingly, this is the opposite of the effect of greater internal mobility, where more flexibility in allocating labor across sectors will amplify cross-sectoral volatility. The inflow of remittances owing to greater external mobility helps finance the trade deficit (Figure 37, panel “C”).

Figure 37.Simulated Developments in Relative Prices, Current Account, Trade Balance, and Wages

Source: IMF staff simulations.

Note: For simulation details, see Bems and Schellekens (forthcoming).

Wages and Remittances

Throughout convergence, the following wage-related developments can be observed:

  • Greater external mobility may contribute to domestic wage inflation (Figure 37, panel “D”). The outflow of labor drives up the marginal product of labor domestically and, therefore, also domestic wages. This helps speed up wage convergence to foreign levels, reducing the incentive to provide labor services abroad. The extent of such wage pressure depends on the severity of domestic labor shortages and mismatches.58

  • Some of the wage gains workers manage to extract by providing labor abroad are offset in real terms because of higher foreign price levels. As a result of their spending time abroad, migrant workers may need to consume substantial amounts of nontradable goods in the destination country. Foreign nontradables, however, are more expensive than in the source country due to sectoral productivity differentials across countries (the Balassa-Samuelson effect).

  • Through remittances, the net gain in wages as a result of working abroad benefits both the migrant worker and any household members left behind in the source country.59 Remittances can be spent on domestic goods, invested, or used to finance a part of the trade deficit. To the extent that remittances fuel the demand for nontradable goods, the relative price of nontradable goods is boosted by their inflow.

Outflows and Return Inflows

Considering the intertemporal nature of the adjustment process, the outflows and return inflows of labor follow this general pattern:

  • Labor initially flows out at high speed. However, as wage levels converge between source and destination countries, the incentive to leave the source country is diminished, and the outflow of workers slows.

  • Eventually, the outflow of workers may reverse (Figure 36, panel “B”), particularly when agents expect persistently higher growth in productivity in the source country.60 This development will provide an incentive to reap the benefits of higher wages abroad early on, since domestic wages will be expected to converge rather quickly.

To the extent that cross-border workers have acquired specific skills and built human capital by virtue of their jobs abroad, the return of these workers will also augment the growth potential of the source country.

Policy Challenges

Greater labor mobility has substantial benefits at the level of the individual but presents a number of challenges at the aggregate level:

  • From the perspective of the individual, greater mobility offers a wider set of possibilities. Insofar as the outflow of labor is the outcome of a decision made under free choice, the outcome is welfare improving to the individual.

  • From the perspective of society, however, the question is more difficult. Does the individual decision impose any externalities on the rest of society? How are these externalities shared across borders? Do national policymakers sufficiently take into account the cross-border externalities?

The challenge for policymakers is to maximize the benefits of cross-border labor mobility, while avoiding volatility by implementing demand-management policies and fostering growth through structural reforms.61

Managing Volatility

The flow of labor across borders has been repeatedly—and, as will be argued, often erroneously—associated with overheating and subsequent cooling (the boom-and-bust cycle). This is perhaps unsurprising in view of the rates of wage inflation recently observed in some countries, as well as the presumed boost of remittances to domestic demand.

Symptoms of Overheating . . .

During the early stages of transition, labor outflows occurred in the context of large unemployment and underemployment figures. Later on, however, domestic labor markets began to experience a tightening to some degree or another, resulting in real wage increases (Figure 38), although this has started to taper off somewhat more recently. This pattern is also reflected in job vacancy rates, which increased steadily (Figure 39), although in Estonia and Latvia they have recently started to fall. Shortages have emerged in specific segments of the labor market, including the construction and services sector, where labor demand has been especially buoyant. With labor markets tighter, incremental moves in the supply of labor due to cross-border mobility have become more easily reflected in wages.

Figure 38.New Member States: Real Wage Developments, 2004–2008:Q1

(Percent)

Sources: Eurostat; and IMF staff calculations.

Notes: Average year-on-year quarterly growth rates, deflated by the consumer price index.

Figure 39.New Member States: Job Vacancy Rates, 2005–07

(Percent)

Sources: Eurostat; and IMF staff calculations.

Note: The job vacancy rate is defined as the ratio of total posts that are vacant to the number of occupied posts plus the number of job vacancies.

Associated with the cross-border outflow of labor is the inflow of remittances. Remittances support domestic economic activities, and, insofar as these activities translate into an increased demand for domestic products, remittances could contribute directly to price and wage inflation through a “remittances accelerator” mechanism. In addition to supporting household and family consumption, remittances may increasingly take on an investment character. The monies remitted by cross-border workers may be invested in domestic equity and real estate markets, thus amplifying existing appreciation pressures on these asset prices and feeding back into overall demand through wealth effects.

. . . or Business as Usual?

Before one can assess the role played by labor mobility in overheating, it is useful to first assess its worth in determining the relative importance of labor and capital in the convergence process (Box 14). In most countries, the combination of anticipated productivity growth and the desire to smooth consumption seems to have been a driving force more powerful than the impact of outward labor mobility. This conclusion is also apparent in the fact that, even if labor has flowed out, capital has continued to flow in—something that would not have been the case had net labor outflows been the dominant factor.62 In sum, if labor plays a more limited role than capital in the convergence process, one can safely conjecture that the role of labor in producing overheating is also more limited.

Box 14.Migration and Economic Convergence in the New Member States

Many New Member States (NMS) are concerned with the economic and social consequences of emigration. Although official statistics are incomplete, populations are declining markedly in some of these countries, owing to both falling birthrates and net outward migration. In addition, recent surveys suggest that potential migration could be substantial, especially in light of the relaxed migration policies that are mandated for European Union (EU) countries by end-2010.

At the same time, it is important to recognize that labor outflows, along with capital inflows, are an integral part of the development process. Growth models predict that countries with relatively low capital-to-labor ratios will attract capital, since the rate of return on capital is relatively high. The models also predict that labor will move abroad, where labor productivity and real wages are higher. The convergence process for a particular country will depend, among other factors, on the degree to which labor and capital are mobile across borders, and the degree of substitutability between capital and labor.

Two questions are particularly important in this respect:

  • Is labor migration unusual in the NMS? Net migration rates and income differentials for the EU-15 countries during 1960–2000 indicate that migration among EU-15 countries was strongly responsive to economic incentives (figure). This estimated relationship is somewhat successful in explaining recent migration trends for NMS, even though outward migration is likely flowing to non–EU-15 countries, as well as to EU-15 countries (first table). The actual net migration rates tend to be lower than the predicted rates for lower-income countries and tend to be higher for countries with income levels closer to the EU-15.

EU-15 Countries: Net Migration Rate and Initial Relative Income, 1960–2000

(Percent of total labor)

Source: Eurostat; and IMF staff simulations.

New Member States: Relative Income and Net Migration Rates, 1995–2007(Annual average, percent)
Net Migration Rate, 1995–2007 1/
Average Income, 1995

(Relative to EU-15)
ActualPredicted
Latvia-0.71-1.9-2.3
Lithuania-0.65-3.7-2.0
Estonia-0.65-2.3-2.0
Poland-0.58-1.2-1.8
Slovak Republic-0.520.1-1.5
Hungary-0.471.5-1.3
Slovenia-0.301.7-0.5
Czech Republic-0.281.7-0.5
Sources: Eurostat; and IMF staff calculations.
  • How important is labor migration for the convergence process? Capital-to-employee ratios have improved quickly for all NMS, especially those with relatively low initial levels (second table). Most of the gains, however, came from capital accumulation rather than from outward migration, suggesting that labor is relatively immobile compared with capital.

New Member States: Changes in Capital-per-Employee Ratios, 1995–2006 1/(Constant U.S. dollars)
Capital per Employee in:Average Annual Percent Change
19952006K/EKE
Latvia10,01728,48016.814.3-0.9
Lithuania11,03623,43310.28.6-0.8
Estonia13,15835,18615.214.6-0.2
Slovak Republic15,85631,5379.010.50.8
Poland17,01131,4607.77.4-0.2
Hungary22,71439,0576.57.10.3
Czech Republic22,87944,3898.58.2-0.2
Slovenia44,39068,0674.86.20.9
Sources: World Bank, Social Development Indicators database; IMF, World Economic Outlook; and IMF staff calculations.

The role played by labor mobility, and its contribution to wage inflation and demand support (e.g., through remittances), need not be seen as causing overheating per se:

  • A degree of wage inflation in domestic labor markets is a natural and optimal feature of convergence when labor is crossing borders.63

  • Remittances allow households to access a wider set of consumption and investment choices, and are therefore a crucial channel through which cross-border labor mobility translates into welfare benefits.64

  • Labor mobility may dampen the oscillations observed in the domestic economy. As labor flows out, some of the demand for nontradable goods is exported, thereby alleviating pressure on domestic resource constraints. As a result, the nontradable price boom and current account deterioration are both smaller (Figure 37, panels “A” and “B”).

Labor Mobility’s Cushioning Role

Labor mobility responds to overheating pressures: the outflow of labor moderates as the economy overheats, thereby diminishing labor’s effect on wage inflation.

  • Consider the case where overheating derives from an overoptimistic assessment of future productivity developments, which drives up present consumption and investment in anticipation of future permanent income increases that will (or may) not materialize.65 Through its effect on relative wages and prices, overheating can have an important impact on the incentive to provide labor services across the border.

  • Compared with an economy that is not overheating (i.e., one in which—in keeping with this example—productivity expectations are about right), an overheating economy will experience smaller labor outflows because local economic conditions are perceived to be better (Figure 40). Thus, relative to the best case of no overheating, labor mobility plays a smaller role in producing wage inflation than the underlying cause of overheating.

Figure 40.Foreign Labor Developments with and without Overheating (Simulated)

(Percent of total labor)

Source: IMF staff simulations.

Note: For simulation details, see Bems and Schellekens (forthcoming).

Labor mobility would also respond in the case of a significant cooling or “bust” in the boom-bust cycle. Whereas most countries have continued to register strong growth, the economic conditions in some countries, particularly those that had experienced overheating pressures previously, have started to turn around or have already done so. With labor markets open internationally, the concern is that the downturn would produce additional outward flows of labor, as well as a smaller inflow of labor from abroad (including a reduced incentive for return inflows). The concern is particularly valid when the wage gap with destination countries is insufficiently closed.

Model simulations illustrate this mechanism (Figure 41). Given expectations about future productivity growth, some labor flows out in the initial periods. If these expectations had been correct (the line denoted “Counterfactual of no bust” in Figure 41), the stock of foreign labor abroad would have started to taper off after a number of periods, reflecting the return inflow of labor. However, if the initial rosy expectations had been proven wrong (“overheating with bust”), the stock of foreign labor may actually continue to grow, reaching its maximum level later.

Figure 41.Impact of Bust on Foreign Labor (Simulated)

(Percent of total labor)

Source: IMF staff simulations.

Note: For simulation details, see Bems and Schellekens (forthcoming).

The magnitude of the labor outflow following a downturn also depends, of course, on whether the downturn is similarly being felt in recipient economies. Indeed, if conditions deteriorate simultaneously in recipient and sending countries, the threat of additional labor outflows may be diminished. Also, region-specific shocks may induce both inward and outward migration. For example, a sector-specific shock in one region may induce an inflow of high-skilled workers from other regions, while producing an outflow of low-skilled workers.

Demand-Management Policies

Against this background, what are the implications for demand-management policies?

  • With respect to episodes of overheating, the key policy implication is to address the source of overheating directly, taking into account that much of the wage pressures caused by labor mobility reflect natural convergence and not overheating. Attempting to limit labor mobility directly or to offset the resulting upward pressure on wages through demand-management policies may hurt the overall economy’s convergence process and, therefore, individual and social welfare.

  • At the same time, from a demand-management perspective, overheating may pose a number of secondary challenges, and the key will be to address these while preserving the benefits of labor mobility. For example, as noted, wage inflation may be a natural consequence of labor mobility. While these inflationary consequences are optimal, the policymaker will need to fine-tune demand-management policies to ensure that wage pressures do not set off a self-feeding wage-price spiral.

  • Policymakers will also need to keep the second-round impact in check to ensure that wage growth does not erode competitiveness. Even where local labor market characteristics, such as low degrees of unionization and high internal labor market flexibility, would suggest that wage growth can be kept in line with productivity growth, the threat of emigration limits the scope for doing so. In designing their policy response, policymakers will need to carefully monitor wage developments and walk a fine line between preserving competitiveness and allowing wages to rise naturally in line with what is optimal.

Fostering Growth

Several challenges to the competitiveness and dynamism of the NMS economies need to be addressed to ensure that these countries not only reorient their economies successfully toward the tradable sector but also utilize resources more efficiently.

Mobilizing Labor Supply and Employment

Most NMS have experienced a significant improvement in labor market outcomes since 2000. Convergence led to a boost in the rate of job creation (Figure 42). As a result, average employment rates for the NMS rose by almost 5 percentage points, although the improvement varied significantly across countries. Similarly, unemployment indicators improved (Figure 43), falling from about 12 percent during the early 2000s to 7 percent in the past few years. Long-term unemployment rates also improved in many countries.

Figure 42.New Member States: Employment Rate, 2000–07

(Percent)

Sources: Eurostat; and IMF staff calculations.

Note: The employment rate is defined as the ratio of number of persons aged 15 to 64 in employment to the total population of the same age group. Values for the Czech Republic and Romania are based on forecasts.

Figure 43.New Member States: Unemployment Rate, 2000–08

(Percent)

Sources: Eurostat; and IMF staff calculations.

Note: The indicator refers to harmonized monthly unemployment rates averaged over the periods indicated. Romania's latest observation is for March 2008.

Notwithstanding these improvements, there is further scope to mobilize and better utilize labor resources in most NMS. While the average employment rate has improved in most countries, it remains in all countries below the Lisbon target of 70 percent. The average employment rate in 2007 stood at 63 percent, with some countries (Poland, Hungary, and Romania) experiencing rates below 60 percent. Also, unemployment rates remain high in several countries (notably the Slovak Republic and Poland, but also Bulgaria and Hungary).

Raising labor market participation rates will help ease pressures on the labor force arising from natural demographic reasons and net migration, both of which reduce the working-age population. As argued by Kaczmarczyk and Okólski (2008), changes in labor market participation may play a bigger role than purely demographic changes through natural population growth and net migration. It is essential that the NMS improve participation rates so that they can successfully meet the challenges they will face.

A number of factors may complicate the mobilization of labor supply and the increase in employment rates:

  • Overheating forces may have eroded the competitiveness of tradable industries, causing them to close down; if reinstalling industries is costly, completing the reorientation stage will become more difficult.

  • Reorientation stage challenges are also more difficult to meet if the labor supply is limited and the skills profile of the workforce has deteriorated through the allocation of resources to the nontradable sector.

  • The foreign debt will need to be serviced with a smaller labor support (assuming that much of the foreign debt remains local while labor migrates).

The process of income convergence is accelerated if policymakers stimulate labor force participation and employment rates. Greater labor market participation and lower structural unemployment could be achieved through better-targeted active labor market policies, less rigid regulations regarding hiring and dismissals, and an improved design of the tax benefits system.

Reducing Labor Market Mismatches

In a number of countries, labor outflows of the young and relatively low skilled have been particularly pronounced. This phenomenon has lowered the rate of wage dispersion across education levels. In Estonia, for example, net wages in 1997 for those with tertiary education were 93 percent higher than for those with only primary education; by 2006, this premium had fallen to 32 percent.66

In countries where mismatches have arisen owing to changes in the composition of gross outflows and inflows, these mismatches will need to be addressed. Similar mismatches may arise from the aging of the populations in many countries. These problems complicate the reorientation of the economy to a high-value-added and competitive export sector.

To offset mismatches, further consideration should be given to relaxing immigration policies, so as to allow larger inflows from non-EU emerging economies.67 In addition, countries could invest in return migration to attract back those emigrants who have, during their employment abroad, gained valuable skills. Some countries have, for example, launched initiatives to induce overseas nationals to “return migrate” to reduce mismatches domestically.68 Policymakers could also consider investing further in education, including tertiary education.

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