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)| false Odling-Smee, J.and B. Zavoico, 1998, “ External Borrowing in the Baltics, Russia and Other States of the Former Soviet Union: The Transition to a Market Economy”, IMF Paper on Policy Analysis and Assessment PPAA/98/5 ( Washington: International Monetary Fund).
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Temprano-Arroyo, H. and R. Feldman, 1998, “Selected Transition and Mediterranean Countries: An Institutional Primer on EMU and EU Relations”, IMF Working Paper WP/98/82 (Washington: International Monetary Fund).
We would like to thank Hamid Faruqee and Susanna Mursula for their contributions and expertise on MULTIMOD. Valuable comments were provided by Bas Bakker, Bernard Brunei, Dimitri Demekas, Robert Feldman, Gaston Gelos, Balazs Horváth, Peter Isard, Peter Keller, Russell Kincaid, and Thomas Wolf. All remaining errors are ours.
This group of countries includes Cyprus, the Czech Republic, Estonia, Hungary, Poland, and Slovenia. The following Central and Eastern European countries (CEECs) are also membership candidates: Bulgaria, Latvia, Lithuania, Romania, and Slovakia.
The general question of current account and external sustainability in transition economies is, however, not addressed. See for example Roubini and Wachtel (1998).
As Havrylyshyn (1998) points out, it is also important to acknowledge that EU enlargement and EMU are not the only mechanisms of further economic integration in Europe. These include, for example, the various forms of cooperation among the states surrounding the Baltic Sea.
Without the option of EU accession, Estonia may have joined not only EFTA but also the European Economic Area, where much of the regulatory requirements are modelled on those of the EU (notably EU policies on mergers, state aid, consumer protection, labor markets, and the environment). In such a scenario, it would have had to carry out many of the policy reforms that are now implemented in the context of EU accession. In addition, some EU requirements also coincide with Estonia’s other international commitments. Most notably, the impact of EU accession will occur alongside the general process of growing international interdependence in which access to world financial markets plays an increasing role. An important challenge for the EU accession candidates in this context will be the evolving international role of the euro, which replaced 11 European currencies at the beginning of 1999. See Feldman et al. (1998).
In amending the Association Agreements with the CEECs in 1997, the EU extended the right for the cumulation of local value added to a significantly larger group of countries, including Estonia. Since then “originating products” can be moved around more widely while still qualifying for preferential tariff treatment. This pan-European cumulation of origin removed potential obstacles for cost-efficient specialization in production and intraindustry trade within the EU periphery and notably improved Estonia’s trade and investment environment. After Turkey was included at the beginning of 1999, these cumulation provisions now apply to 32 countries, namely the members of the EU, EE A and EFT A, the 10 associated CEECs, as well as Andorra, San Marino, and Turkey. See Temprano-Arroyo and Feldman (1998).
Estonia has signed bilateral Free Trade Agreements with Hungary, Poland, the Czech Republic, Ukraine, the Slovak Republic, Slovenia and Turkey. It is a member of EFT A and has ratified the Baltic Free Trade Agreement with Latvia and Lithuania. Estonia gained WTO membership status in late 1999. For a detailed analysis of Regional Trade Arrangements with Estonian participation see Sorsa (1997).
Estonia accepted the obligations of Article VIII of the IMF’s Articles of Agreement in August 1994. Its currency board arrangement has been analyzed by Bennett (1992, 1994), Pautola and Backé (1998), Sepp (1995), and Baliño et al. (1997).
If the equalization of factor prices between two countries were to fully happen through trade, a further strengthening of the economic linkages via joining a common market would not enhance allocative efficiency. However, given economies of scale as well as differences in technology, economic structures, and innovative capacity, increased factor mobility is still likely to lead to allocative welfare gains. See Robson (1987).
For example, it has been shown that trade barriers versus non-EU members increased following the creation of the European single market in January 1993. See Taube (1992).
The main countries affected are Australia, Canada, Japan, New Zealand, Taiwan Province of China, and the United States to which the EU accords only most-favored-nation (MFN) treatment. The impact is limited for Russia and the Ukraine which have preferential access to the EU market on the basis of their Partnership and Cooperation Agreements.
On the possible fiscal implications of the CAP see further below.
See for example the analysis of welfare effects of the European Communities’ Common Market Program by Emerson et al. (1988).
The major rating agencies have recently confirmed Estonia’s investment grade rating on foreign currency denominated long-term debt (Moody’s: Baal, Standard and Poor’s: BBB+, FitchIBCA: BBB; situation end-September 1999).
The EU financial sector directives include a large body of regulations on banking, capital markets and insurance. For a description of the EU framework in this area and the degree of compliance by Estonia see Cavalcanti and Oks (1998).
From the date of membership, the regular EU support mechanisms will apply while funding through PHARE will cease.
Staff estimate on current growth projections. For further discussion on these issues see below.
This highlights the importance of the introduction of the euro, which will accelerate the emergence of a larger and more liquid Europe-wide financial market, for the CEECs. Countries closely linked to the euro area will benefit from the tendency for lower interest rates in the euro area, which is bound to foster investment and output growth in the EMU periphery. See Russo (1998).
Additional grant and loan financing may also become available bilaterally from current EU members.
As of end-March 1999, fiscal reserves in the SRF amounted to EEK 2.8 billion, equivalent to 3.5 percent of projected 1999 GDP.
It is, however, likely that the EU will require the abolition of the recently introduced profit tax deductibility of fixed costs for all enterprises outside Tallin over and above the customary deduction of depreciation. This measure was approved by parliament in January 1999 and became effective retroactively from January 1, 1998. It is also questionable if the EU would accept the maintenance of “free-zone status” for a number of ports and towns. See Cangiano and Mottu (1998) who discuss EU and OECD efforts to tackle harmful preferential tax regimes. On other taxes, the Estonian authorities have already initiated work on preparing a medium-term plan for gradually replacing the land tax with a property tax, which is also required by the EU. For details on Estonia’s current tax system see IMF (1998) and Berg (1997).
For agricultural goods, the average trade-weighted external tariff of the EU is 16.4 percent.
Budgetary spending will also be affected significantly by decisions in other, non-EU related domestic policy areas, including pension reform.
For example, the EU has identified the need to increase staffing in the Customs Board, the National Tax Board, the State Audit Office, and institutions responsible for enforcing veterinary and sanitary conditions and controls as well as health and safety standards at work.
Assuming an increase in the number of general government employees by not more than 2,000 persons over and above the current level of slightly less than 140,000.
EU financial assistance for ISP A projects is normally 75 percent of the public expenditures of a project, although the European Commission can propose to increase it to 85 percent in exceptional circumstances. The costs of technical support and feasibility studies can be financed exceptionally at 100 percent, but the costs for such operations cannot exceed 2 percent of the ISPA budget. The Commission has indicated that Estonia’s share of total ISP A resources will be in the range of 2 to 3.5 percent.
Introducing the CAP will of course have a direct favorable impact on producers and an immediate negative impact on real incomes of consumers. Leaving redistributive effects aside, the net effect on aggregate GDP should be minimal or zero according to World Bank estimates.
Under current rules, EU Structural Funds are available to member countries if their GDP per capita is lower than 75 percent of the EU average measured at purchasing power parity levels. With a per capita income of roughly 30 percent of the EU average, Estonia falls well below the current threshold. Enlargement, which will result in a lower EU average, will not change this situation. See Oxford Analytica (1998).
The Structural Funds include the Social Fund (ESF), the Regional Fund (ERDF), part of the support for agriculture (EAGGF), and aid for fishing communities (FIFG). For the period 1994-99, total assistance provided to members through the Structural Funds was ECU 138 billion (Begg 1998).
This rough estimate does not account for CAP-related transfers. Note that an increase in capital spending will have potentially sizeable recurrent cost implications. In the absence of credible estimates and projections, these have not been considered in the analysis here.
The “derogations” are temporary, except for the United Kingdom and Denmark. The inclusion of actual transitory periods in the EU accession treaties concerning these institutional criteria appears unlikely since the membership applicants have expressed their preference to join as soon as possible. Even if these accession candidates make rapid progress on institutional reform and macroeconomic convergence, however, concerns on the side of the EU about real and structural convergence remain. See Feldman et al. (1998).
The most important of coordination and surveillance procedures are the broad economic policy guidelines, the convergence programs and the excessive deficit procedure. For detailed indications on the respective rights and obligations see Temprano-Arroyo and Feldman (1998), and Köhler and Wes (1999).
ERM II is designed as a flexible system with wide standard fluctuation bands (±15 percent), timely realignments, and the possibility of progressively tighter exchange rate links. Participation will be voluntary. The system is asymmetric to the extent that any intervention in the foreign exchange markets by the ECB must not interfere with the ECB’s primary objective of price stability. The costs of intervention and realignment are thus largely borne by the country outside the euro area. For a discussion of the implications of EMU for exchange rate policies in Central and Eastern Europe see Kopits (1999).
Under EMU, banking sector supervision remains a prerogative of national supervisory authorities. With a view to the cross-border activities of banks, regular meetings of these authorities with the ECB are held. The central bank will also need to assure to make the domestic payments system compatible with the Europe-wide real time gross settlement system (TARGET) through which the ECB conducts monetary policy.
With competition bound to intensify, the introduction of the euro may yet prove to be a catalyst for economic restructuring in Europe. This argument in support for monetary union rests on the notion that once intra-European market segmentation has vanished, governments will necessarily tackle structural rigidities on the labor and product markets. It contrasts the reasoning based on the theory of optimal currency areas which sees the exchange rate as an essential policy instrument as long as factor mobility and public transfers do not ensure a certain degree of economic homogeneity among countries. Under such circumstances, the loss of sovereignty over monetary and exchange rate policies is deemed to impose excessive adjustment cost on the real economy.
While the introduction of the euro has removed currency risks as a source of interest rate differentials within the euro area, the remaining interest rate spreads mirror differences in country risk, in part linked to diverging fiscal and structural policies and performance.
In principle, an increase in the current account deficit need not be harmful at Estonia’s stage of economic development and in light of the policy credibility derived from a successful EU accession strategy. Concerns about the sustainability of an accession-related widening of the current account deficit seem nevertheless generally warranted in situations where this deficit is already high. This seems particularly relevant in the context of a currency board under which a shortage of foreign capital inflows will automatically be reflected in higher domestic interest rates. In a crisis scenario, such a built-in increase may not be enough to attract foreign capital or prevent a reversal of inflows. The scope for the central bank to raise interest rates remains very limited even under these circumstances.
The process of EU accession lends itself well to a model-based simulation since it affects all sectors of the economy and requires a forward-looking perspective. Also, the small open economy model is likely to be good proxy for Estonia given its small size, openness to trade and capital flows and strong international economic linkages as outlined above.
This model contains parameter estimates for a small open industrial economy. Most notably, developments in such a small economy have no bearing on international prices, excluding any feedback effects. For further specifications of the model see Appendix. For a detailed technical description of the underlying theoretical assumptions and the structure of the latest version of MULTIMOD see Laxton et al. (1998). A description of MULTIMOD and the equations defining the small industrial country model are also accessible on the IMF website.
While the bulk of EU-related inflows is likely to involve investment grants, some current transfers (e.g., technical assistance, CAP support) will also take place. According to the IMF’s Balance of Payments Manual (Fifth Edition, 1993), investment grants should be classified as capital transfers.
See Appendix for a description of these behavioral assumptions. Simulations were also made without accounting for foreign grant financing. These suggest that in the absence of EU transfers there would likely be a significant financing shortfall as well as a stronger external imbalance than shown in this scenario.
The baseline outcome reflects the projections included in the IMF’s World Economic Outlook (WEO). For the recent medium-term macroeconomic framework for Estonia see IMF (1999). In this baseline, a zero fiscal balance and a gradual decline of the current account deficit are assumed over the medium term.
The level of consumer prices is likely to rise following the introduction of the CAP since the CAP includes reference prices for agricultural products. This effect is no taken into account in this scenario. Estonia’s inflation path will be particularly relevant with a view to meeting the Maastricht convergence criteria and joining the euro area.
In particular, the simulation does not accommodate changes in economic policies beyond those underlying the WEO baseline scenario.
The magnitude of the MPC effect depends on the initial level of wealth, while the wealth effect depends on the change in wealth due to a change in interest rates.