Five Years After: European Union Membership and Macro-Financial Stability in the New Member States

The proximity of the European Union, the prospect of membership, and actual entry by the New Member States (NMS) increased economic and financial integration in the region, leading to fast economic growth based on sizeable capital inflows. EU membership helped in developing sound macroeconomic and financial stability frameworks in the NMS. However, these frameworks remain work in progress and as such could not safeguard against private sector exuberance or risky policies, especially in the face of an unprecedented global financial crisis. Hence, more prudent policies and further strengthening of policy frameworks, especially with respect to financial stability, seem warranted.


The proximity of the European Union, the prospect of membership, and actual entry by the New Member States (NMS) increased economic and financial integration in the region, leading to fast economic growth based on sizeable capital inflows. EU membership helped in developing sound macroeconomic and financial stability frameworks in the NMS. However, these frameworks remain work in progress and as such could not safeguard against private sector exuberance or risky policies, especially in the face of an unprecedented global financial crisis. Hence, more prudent policies and further strengthening of policy frameworks, especially with respect to financial stability, seem warranted.

I. Introduction

In May 2004, eight Central and Eastern European countries—the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia—joined the European Union (EU). The entry of these “new member states” (NMS) was the biggest enlargement of the EU in terms of population and area (by 19 percent and 22 percent, respectively), although it was a relatively smaller increase in terms of economic output (about 9 percent).2 It was a major milestone in the NMS’ transformation from centrally-planned to market-based economies.

This study uses the five-year anniversary of the EU enlargement as an opportunity to analyze the impact of the EU membership on the economies of the NMS and the fifteen “old” member states (OMS).3 Specifically, the study focuses on macroeconomic and financial stability issues, and attempts to isolate the impact of EU-level frameworks, such as the Maastricht criteria, the Stability and Growth Pact (SGP), the Lisbon agenda, and the financial integration and prudential policies. This analysis is useful not only for an ex-post assessment of past developments, but also for a forward-looking discussion on the opportunities and challenges ahead. Also, this analysis may be useful for gauging the potential impact of possible future enlargements of the EU. It is only a preliminary analysis, because the period of 5 years may be too short to pass a definitive judgment. Importantly, this timeframe covers two very distinct sub-periods: one of historically strong global growth (2004–07) and the onset of an at least equally historic financial crisis (2007–09) that undoubtedly represents the greatest economic test the region has faced since EU accession. The challenge facing the NMS now is to preserve and further build on the achievements of the recent years in a much more adverse global context.

To preview the main findings, the paper finds evidence of increased economic and financial integration between “old” and “new” Europe, a process that started well before May 2004. This has been reflected in rapid economic growth in the NMS, faster than what could be expected given the economic fundamentals. There is also some evidence of improved macro-financial performance, although there have been substantial cross-country differences, and challenges remain in terms of inflation control, fiscal adjustment, structural reform, and financial stability. The study provides some econometric evidence on links between EU membership and domestic economic outcomes, even though the impact of the EU membership is not easy to separate from other factors (it is difficult to construct a plausible counterfactual).

The increased economic and financial integration, while generally beneficial, may have made the NMS more vulnerable to the cross-country transmission of shocks. The global financial crisis that hit with full force in 2008 and is still ongoing has been a major real-life “stress test” of the enlarged EU. It has already had an impact on advanced economies as well as emerging markets, outside as well as inside the EU. A global examination of the crisis highlights a number of policy issues to be addressed, including: (i) managing the ongoing financial and economic fallouts of the crisis, as well as the exit strategy from current exceptional actions; (ii) preventing future recurrences of financial market upheaval; and (iii) designing a better international financial architecture to prevent adverse spillovers and enhance financial markets’ functioning (IMF, 2009a).

EU membership had some benefits for the NMS during the crisis. This included the EU’s balance of payments facility and reverse purchase (repo) arrangements by the ECB with some NMS central banks, which have provided useful safety cushions. At the same time, the fact that the crisis hit some NMS so hard serves as a reminder that EU membership, while useful, is not a panacea.

The empirical analysis in this paper suggests that markets may have been under-pricing the risks in the NMS prior to the crisis. During the crisis, this under-pricing has disappeared. Market pricing has started to reflect more closely the quality of macroeconomic policies, as countries with lower inflation and lower deficits have faced substantially lower spreads.

The financial sector has played a key role in the transmission of the crisis. Given the high integration of NMS banking systems in the rest of the EU, the NMS authorities need to make the best of the cross-border and EU-level arrangements, and be proactive in the EU-wide debate on improving these arrangements. At the same time, the NMS should make full use of their domestic policy tools, including sound prudential policies, consumer protection arrangements, and financial education.

The structure of the paper is as follows. Section II reviews the macroeconomic performance of the NMS countries, highlighting the increasing economic and financial integration between the NMS and the rest of the EU, as well as the increased vulnerabilities. Section III analyzes the impact of EU membership and EU-level policy frameworks on domestic policies and economic outcomes. Section IV concludes.

II. Macro-Financial Performance and Vulnerabilities

A. Economic and Financial Integration

The NMS’ EU entry has been a major step in the political integration within Europe. It has also contributed to further deepening of the economic and financial linkages between the NMS and the OMS. Economic and financial integration has been an ongoing process that started in the early 1990s and continues even after the EU accession. The emerging economies of Central and Eastern Europe have gone through a successful period of reform that has resulted in unprecedented progress. Compared to the early 1990s, standards of living have improved dramatically, life expectancy has gone up, and access to higher education has multiplied (see, e.g., The variety of goods and services (both financial and non-financial) available to NMS consumers has become more similar to that in the OMS. The foreign capital entering the NMS economies (including the financial sector) brought with it know-how and support from resourceful foreign parents with a long-run perspective. The improved access to western markets has been reflected in rapid growth of exports and NMS’ increased shares in the world market (Figure 4). The increased financial integration of NMS with OMS facilitated consumption smoothing, because of the improved access to cross-border finance (indeed, the NMS have also been major recipients of cross-border capital flows, both foreign direct investment and portfolio investment, which are likely to have contributed to a decline in consumption volatility in recent years). Also, financial integration has contributed to greater shock absorption capacity, as the foreign-owned banks could potentially tap into the larger pool of capital available to their foreign parents.


Imports from OMS

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: IMF’s Direction of Trade Statistics, authors’ calculations.

One piece of evidence for the increased economic integration between the NMS and the rest of Europe is the growth of trade linkages. For example, the share of the NMS’ exports in EU imports, has increased about 2.5 times between 1993 and 2008. This included a doubling of the NMS’ market share already before EU accession. However, the rapid increase in the export market share continued, and even slightly accelerated, after accession. In the same time period, the share of other emerging markets also increased, but at a much slower rate (text chart). The growth of NMS exports to the OMS has been mirrored by NMS imports from the OMS, which has also been increasing at a rapid pace.


Exports to OMS

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: IMF’s Direction of Trade Statistics, authors’ calculations.

The growing interlinkages are also illustrated by the increasing degree of business cycle synchronization between the NMS and the euro area. Business cycle correlations between various NMS economies and the euro area now exceed those for Greece and Portugal (IMF, 2007b). Production structures in the NMS are characterized by a higher share of agriculture and a lower share of services, but are gradually converging to those in the euro area. Inflation correlations and variance shares explained by common euro-area shocks are lower than for the OMS, but the transmission of common euro-area shocks to the NMS does not differ significantly from those to the OMS (Eickmeier and Breitung, 2005). About two thirds of NMS trade is with the euro area.


Current Account Deficit and GDP per Capita

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Sources: Eurostat; IFS, National Statistical Offices; and authors’ estimates.

An important factor in the economic integration between the NMS and the OMS has been financial integration, which has been associated with a rapid transformation of the NMS financial systems. Foreign banks, mostly from the OMS countries, have entered the NMS markets, mostly by acquiring recently privatized NMS banks. At present, OMS-headquartered banks control a major part of the NMS banking assets. The share of foreign ownership in NMS banking systems has increased substantially, and is higher than in Western Europe and in emerging markets in other regions of the world. This also applies to other segments of the financial sector, albeit to a lesser degree.


Share of foreign-owned banks

(in percent of total assets, 2004)

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

One measure of the degree of financial integration is the convergence in nominal interest rates. This was in part driven by declining risk premia relative to the OMS, a trend that proceeded until the onset of the global crisis (text chart). The crisis has led to a reappraisal and repricing of risks in the individual countries. This has renewed the cross-country differentiation in interest rates, not only between the NMS and the OMS, but also within each of these groups (the within-group differentiation among the OMS has been lower than among the NMS, but it has still been sizeable compared to previous years).


Government bond spreads: NMS and other emerging markets

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Financial integration has been accompanied by rapid credit growth in the NMS states. The speed of the credit growth differed across the NMS countries. While the Baltic NMS have seen credit growth rates significantly above comparable countries, the credit growth rates in the other NMS were broadly in line with their levels of financial development (text chart). The rapid credit growth led to substantial financial deepening in the NMS; however, the developments during the 2008– crisis suggest that some of this deepening may not have been sustainable.


Financial Deepening, 2003-07

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Sources: National Banks, International Financial Statistics, and IMF staff estimates.

The NMS have also made some progress in developing their local capital markets. There is some evidence that the degree of integration of the NMS’ equity markets has increased in recent years (Cappiello and others, 2006) and that the NMS’ bond prices now exhibit fairly high co-movement vis-à-vis the OMS (Germany). However, the rate of development has been widely disparate across countries and market segments, underpinned by the varying degrees of progress made in key areas such as establishing pricing benchmarks; adopting, implementing and enforcing securities laws and regulations; encouraging the growth of an institutional investor base; and providing adequate trading infrastructure. Iorgova and Ong (2008) provide an overview of the trends in the region’s local capital markets, and examine the main factors that have contributed to their growth and effectiveness to date.

B. Rapid Economic Growth

After the volatile 1990s, growth accelerated substantially across the emerging markets in the early 2000s, with emerging Europe (including the NMS) growing at rates second only to those achieved in emerging Asia. Tighter integration with advanced economies has allowed emerging European countries, including the NMS, to grow considerably faster than economies in other regions with similar income levels, allowing them to display real convergence (text chart). Convergence has also been taking place within the NMS country group: economies with lower starting per-capita GDP have tended to grow faster (Figure 1)4

Figure 1.
Figure 1.

Growth Performance in the NMS and Other Economies

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: IMF, World Economic Outlook.

Convergence in NMS and in the Rest of the World, 2003-07

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

A comparison of the GDP growth rates in individual NMS countries (text chart) shows relatively high growth rates in the NMS, both in the run-up to accession and in the years since (with only Estonia and Hungary showing a slowdown in 2004–08 relative to 2000–03).


GDP growth before and after accession

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: authors’ calculations based on the IMF’s World Economic Outlook (2008-13 are estimates)

This rapid economic growth allowed the NMS economies to increase their share in the world’s economic output.5 The share of the NMS has been increasing consistently, from about 1.5 percent in the early 1990s, to an estimated 2.1 percent in 2008. Despite the impact of the global financial crisis, the share is projected to remain broadly stable throughout 2013, in the IMF’s latest (October 2008) World Economic Outlook (text chart). To put the NMS’s share in perspective, the share of the OMS has been as high as 24 percent in 1989, but it has fallen to 20 percent in 2008. EU enlargement has therefore been able to slow down the slide in EU’s share in the world’s output, even though it has not stopped sliding down completely (text chart).


NMS share in global output

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: World Economic Outlook (2008-13 are projections); authors’ calculations.

EU’s share in global output

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: World Economic Outlook (2008-13 are projections); authors’ calculations.

C. Exchange Rates and Prices

The NMS’ real convergence (in incomes) towards the OMS has been accompanied by nominal convergence, as price levels (substantially lower in the NMS than in the OMS) have been converging to the OMS levels. This took place to some extent via higher inflation, but mostly through nominal exchange rate appreciation relative to the euro (Figure 2) and other OMS currencies. Both adjustments imply an increase in the relative price level of the NMS countries (text chart).

Figure 2.
Figure 2.

Financial Market Vulnerability Indicators in the NMS, 2006–08

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: Bloomberg L.P., authors’ calculations.

IMF staff’s multilateral and bilateral exchange rate assessments for the NMS have generally suggested that real exchange rate appreciation—which exceeded 1½ percent per year in most NMS in the last decade—has been of an equilibrium nature (text chart), even though exchange rates are considered to be overvalued in one or two NMS.6 Thus, other factors may have been at play, probably relating to the rapid structural transformation of NMS economies that followed their opening up to the world economy (see IMF, 2007b for a discussion of these factors). During the crisis, most of the NMS currencies have been depreciating fast.


NMS GDP per Capita and Prices, 1995-2007

(in percent of EU-25 levels)

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: World Economic Outlook, authors’ calculations.

The NMS have been relatively successful in bringing inflation down and keeping it under control. The average consumer inflation rate in the NMS has been below the average of other emerging markets (text chart). However, some of the NMS countries experienced credit-driven booms accompanied by accelerating price increases.



Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: IMF’s World Economic Outlook, authors’ calculations.

D. Risks and Vulnerabilities

The benefits associated with rapid economic and financial growth have, however, come with risks and vulnerabilities. The fast economic and financial growth has been associated with large imbalances in several NMS economies, raising questions about sustainability. Against the backdrop of EU membership, domestic credit and demand booms have been unfolding in most of the NMS prior to the global crisis. Expectations of fast convergence have generated large capital inflows in search of high returns in the region. Capital inflows have contributed to very high levels of external debt in some countries. Although converging economies are expected to attract foreign savings to help finance investment and smooth consumption, current account deficits in several NMS economies have been too large in comparison with the rest of the world (Table 1), even after taking into account their income levels (text chart).

Table 1.

Macroeconomic Performance in the NMS and Other Emerging Market Economies

(growth rates in percent, unless noted otherwise)

article image
Source: Authors’ calculations based on data, estimates, and forecasts from the IMF’s World Economic Outlook.

The forecasts are surrounded by substantial uncertainty given the global financial crisis.


Current account balance

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: IMF’s World Economic Outlook, authors’ calculations.

The favorable market assessment of the NMS economies has proved to be somewhat of a mixed blessing. Country risk premia in the NMS seem to have declined earlier than they did in the catching up OMS prior to their EU entry. Financial markets have viewed the NMS favorably, at least before the recent global crisis, pricing their sovereign assets some 50–100 basis points below the levels that would be expected based on standard policy fundamentals (Luengnaruemitchai and Schadler, 2007). The NMS’ relative success in macroeconomic stabilization and structural reforms and the EU accession seem to have contributed to rapid interest rate convergence, even though global factors (low interest rates, ample liquidity, and a widening of the investor base for emerging markets) have played a significant role as well. This contributed to massive capital inflows to the NMS (text chart), in the form of direct investment (especially in the Central European NMS), bank loans (especially in the Baltic countries), and portfolio investment.

The large capital inflows implied vulnerabilities. Convergence-driven booms in the NMS were associated with rapid credit and domestic demand growth, appreciating real exchange rates, and inflationary pressures. This was not dissimilar to developments in the catching up OMS. Rapid credit expansions have raised concerns about overheating, widening external imbalances, and rising balance sheet risks in some NMS, especially those where domestic borrowers have been contracting loans in euros and other foreign currencies (mostly the Swiss franc and Japanese yen), leading to a build-up of currency mismatches in the private sector balance sheets. The share of foreign currency lending in most of the NMS exceeded the levels of Western European, Latin American and East Asian emerging markets. Currency mismatches made the private sector vulnerable to exchange rate depreciation, and through credit risk, the NMS banking sector might also be affected (IMF, 2007b).


Ratio of Short-item Debt (Remaining Maturity) to Foreign Exchange Reserves, 2007

(in percent)

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Many of the same factors that led to improvements in the economic performance of NMSs also figure prominently as possible risks. Enlargement may have led to inflated expectations, and financial integration may have allowed these to result in sizeable financial risks in some NMS. Integration has also increased the NMS’ exposure to risks and shocks originating elsewhere. Tighter linkages, which contributed to higher growth in the past, could also presage a slowdown due to coupling.7 In particular, cross-border exposures by international banks, mostly from advanced European countries, helped in increasing financial intermediation, but also created new channels of contagion. The reverse of linkages leading to growth could be spillover effects causing a slowdown in the OMS.


NMS: Capital Flows net

(in percent of GDP)

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: IMF, World Economic Outlook.

The global financial crisis of 2008 has put into spotlight the dependence of the NMS financial systems on foreign funding (text chart). In late 2008, the crisis spread virulently through emerging Europe, triggering a sharp slowdown in capital flows to the region. In any case the cost of funding for all sovereign borrowers rose significantly, in some cases to near prohibitively expensive levels and access was severely curbed.

The increase in the NMS spreads in 2007–08 can be viewed in part as a dissipation of the so-called “halo effect.” Analyzing spreads on NMS sovereign bonds in early 2000s, one could find that while a fundamental (economic) analysis pointed to rising vulnerabilities in some of the NMS economies, markets remained optimistic, compressing sovereign bond yields. Hauner, Jonas, and Kumar (2007) and Luengnaruemitchai and Schadler (2007) find a presence of the “halo effect” for 2001–06 and 1995–2005 data, respectively.8

To analyze the presence of the halo effect, an econometric analysis is used to identify the role of fundamentals and global liquidity conditions in determining the level of spreads on foreign currency denominated bonds—sovereign spreads—issued by emerging market countries (Appendix I). The estimation results are encouraging in that the underlying specification is robust and consistent with previous estimates in the literature. In particular, better fundamentals (lower economic, financial and political risks) are associated with lower sovereign spreads. The residuals from the regression (text chart) suggest that after controlling for global liquidity conditions and fundamentals, the level of spreads of the NMS, which has been low and stable by emerging markets standards up to 2006, has returned to the “fundamental” levels (and even slightly above) in 2007–08. In other words, the NMS-wide halo effect seems to have disappeared during the global financial crisis. At the same time, it still holds that those countries that adhere more closely to the Maastricht criteria tend to have lower spreads and face less strong market pressures (Figure 5). This is consistent with the findings of Debrun and Joshi (2008), who, using data for 1990–2005, do not find an EU-wide “halo effect;” instead, they find that countries adhering more closely to the EU’s fiscal rules tended to have lower bond spreads (which is likely to be a fiscal soundness effect rather than an EU effect).


Residuals from the FE regression for sovereign spreads

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

The ongoing financial crisis has increased the risk of a sharp slowdown or sudden stop in emerging markets in general, including the NMS. The vulnerabilities are worsened by macro-financial linkages: real economic developments, such as risks of slowdown in (nominal) income growth, interest rate and exchange rate instability, asset price corrections, can feed back into the financial sector. In view of these risks, the NMS country authorities have taken a range of steps (Appendix II illustrates the range of approaches). Two NMS countries, Hungary and Latvia, have asked the EU and the IMF for financial support (Box 4).

III. Impact of EU Membership: Preliminary Evidence

The adoption of the EU’s “acquis communautaire” has had a major impact on the legal, regulatory, and policy frameworks of the NMS. In the macro-financial area, the main EU-level frameworks include the Maastricht criteria, the SGP, the Lisbon agenda, and the financial integration and prudential policies (notably the Financial Services Action Plan and the Lamfalussy process). The EU-level frameworks aim to increase policy harmonization, and have numerous effects on countries’ macroeconomic and structural policies. Importantly, the frameworks impose constraints on discretionary policy making, presumably making the member country policies more predictable and their economies more stable than they would have been otherwise.

This section addresses the question how EU membership has affected macroeconomic performance and vulnerabilities in the NMS. It aims to identify the impact of EU membership as such, and of key EU-level frameworks, on macroeconomic policies and outcomes in the NMS countries. To answer this question, it tries to separate the impact of EU entry and EU-level frameworks from other effects, such as global shocks and shocks that are specific to individual NMS economies. The following subsections examine, in turn, the impact of EU membership on economic convergence, market perceptions, macroeconomic stability, structural reforms, financial stability, and crisis management in the NMS.

The evidence provided here can only be preliminary. Measuring the impact of EU membership rigorously is challenging, for several reasons. First, the impact of EU entry did not materialize in one go. The 2004 entry date, while a natural cut-off point, is only a step in a process of economic integration and policy convergence that started well before 2004 and has continued since. Second, the benefits of being in the EU may come to fruition only over a longer period of time, perhaps decades. So, 5 years may provide only very preliminary evidence. Third, it is rather difficult to construct a plausible counterfactual, because there are underlying factors (institutional and other) that influenced both the NMS countries’ macroeconomic performance and the fact that they have been accepted to the EU. Notably, economic and policy developments related to EU entry are intimately interwoven with those related to the transition from centrally-planned to market economies. (In other words, it is not trivial to find an economy that would be the same as the NMS except for the fact of EU membership.) Finally, the past five years have been shaped significantly by unusual global cyclical developments (a global boom-bust cycle), which may have obscured countries’ underlying long-term structural performance. To overcome these challenges, this study seeks to isolate the impact of EU membership using an econometric analysis that includes a broader group of countries and controls for various factors influencing their macroeconomic performance.

To give a preview of the main results, an econometric analysis of GDP growth provides evidence of a “bonus” associated with EU membership, i.e. higher growth rates in the NMS than could be explained by fundamentals. Another key finding is that until the global crisis, there was some evidence for an “EU halo effect,” i.e. relatively lower sovereign bond spreads in NMS than could be explained by the fundamentals; however, this halo effect disappeared in 2007–08, as spreads returned to (or even overshot) fundamentals.

In the more detailed analysis, this paper attempts to isolate the impacts of the EU-level institutional frameworks, namely the Maastricht criteria, the SGP, and the Lisbon agenda. The conclusion is that those frameworks played a useful role by putting emphasis on rules-based policies. The Maastricht criteria provided the basic macroeconomic objectives, the SGP fleshed out the fiscal details, and the Lisbon Agenda is the strategy for structural reforms, with a focus on growth and jobs. However, adherence to these frameworks has been uneven, which helps explain the differentiation in outcomes. Domestic governance frameworks and consistency between those frameworks and the EU rules matter.

A. EU Membership and Economic Growth

To what extent can the rapid output growth that the NMS have experienced in recent years be attributed to EU enlargement? One piece of evidence is the relationship between countries’ GDP per capita and their growth rates, which has been significantly negative for EU countries, suggesting strong convergence (text chart). This contrasts with the global picture, which does not indicate significant world-wide convergence during the same period.9


Convergence in NMS and in the Rest of the World, 2003–07

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

The rates of growth recorded by the NMS economies were higher than what would be predicted by the Europe-wide regression (text chart), suggesting a possible “growth bonus” related to EU membership. Specifically, the GDP growth rate in the NMS countries was on average 2.5 percentage points higher than would be predicted by the Europe-wide regression.10

The difference in growth dynamics between the new and old member states is even more striking when overall output growth is decomposed into changes in production factors (labor and capital) versus changes in technology.11 The results suggest that most NMS are benefiting from a structural transformation: growth in the NMS (and elsewhere in emerging Europe) has been driven primarily by total factor productivity (TFP). Moreover, countries with higher TFP growth have been growing faster and the list of EU countries with the highest technological growth coincides perfectly with the NMS list. Capital accumulation has also been important in most countries. Labor, in contrast, has added less and has even registered a negative contribution in some countries, with emigration a key factor. The analysis also indicates that there are substantial differences among individual NMS countries, with average annual TFP growth rates in a wide range, from 2 percent to 6 percent. Such a variation goes beyond the differences among previous EU entrants (where the variation of average TFP growth rate is roughly from 0.6 percent to 2.9 percent).

It is illustrative to compare developments in the NMS with those that took place in earlier entrants during previous waves of EU enlargement. Just like the NMS, these earlier entrants saw strong growth following accession, aided by capital inflows (and structural funds). But there was also substantial variation. In some of the earlier entrants, large FDI inflows raised productivity. In others, credit boosted consumption and housing, while productivity growth slowed sharply and competitiveness failed to keep up with the core EU member states. Which way the NMS will go remains an open question. On the positive side, most NMS have been able to keep their real unit labor costs relatively well in check. In addition, productivity growth in the NMS has been relatively high in recent years. However, low FDI and slow technological upgrading of production present risks to the continuation of the productivity catch-up. It is therefore important to pursue structural policies that foster investment in high-productivity projects. Such policies encompass, among other things, reforms that encourage economic flexibility, public investment in education and infrastructure, and well-functioning financial markets.

To identify the sources of growth in the NMS more rigorously and distinguish more clearly the part that is due to EU membership, a detailed growth regression was estimated, with EU membership as an additional explanatory variable (“factor of production”). The results (Box 1) suggest that about 1.5 percentage points in the relatively higher growth rates in the NMS can be traced back to factors such as their progress in liberalization and their success in stabilizing inflation (progress on these fronts may in turn be influenced by EU-level frameworks, such as the Maastricht criteria, even though it is difficult to establish a causal relationship—more on this in the next section). Even after adjusting for these identifiable factors, there still seems to be a “growth bonus” associated with EU membership, estimated at about 1 percentage point of the GDP growth rate.12

Estimating the Impact of EU Membership on Output Growth

Following a methodology used by Schadler and others (2005) and Vamvakidis (2008), an econometric growth model was estimated on a sample of 106 developed and developing economies in 1996–2007. The estimated specification is

Real GDP per capita growth = 11.14 (2.95)**1.43(4.51)***initial real GDP per capita  7.03(3.89)*** age dependency rate + 0.12(3.89)*** investment/GDP + 0.02(1.78)* university enrollmentratio0.014(2.32)** inflation rate + 0.62(3.01)** index of economic freedom in 1995+0.85(3.98)*** change in the index of economic freedom during 1995-2005 + 0.98(1.82)*dummyvariable of NMS+0.67(1.69)* dummy variable for Africa.
  • ***, **, and * denote statistical significance at the 1, 5, and 10 percent level, respectively; the number of observations is 106; the adjusted R2 is 0.62; heteroscedasticity-consistent t-statistics are in parentheses.

The results suggest that a country with a relatively low income level, a low dependency ratio, a large investment share, a low inflation rate, and a relatively educated population grows faster, other things being equal. The index of economic freedom (, which measures a number of different aspects of macroeconomic and structural policies and reforms, has a positive and statistically significant estimate. The NMS’s income levels have been significantly lower than those of the OMS, and they have scored relatively well on most of the other explanatory variables, which explains a major part of their relatively high GDP growth rates in 1996–2007. In addition, the dummy variable for the NMS has a positive slope coefficient (as does the dummy variable for African countries). This suggests that the NMS’s per capita GDP has been growing faster, by about 1 percent per annum, than can be explained by the growth determinants identified above. This may reflect a “growth dividend” related to the transition that the NMS have gone through after the initial economic collapse in the early 1990s. However, this growth dividend may not carry over to the future, or at least not to the same extent. (Similarly, the positive sign of the dummy variable for African countries is a reflection of the fact that the GDP growth rates in Africa were much higher in 1996–2007 than in the previous decades, an effect that may or may not continue in the future.)

There has been increasing evidence that the integration has growth benefits not only for new, but also for old Europe. One factor in this are positive spillover effects. Econometric estimates by IMF staff suggest that the accelerated growth in emerging Europe in the past 5 years has contributed 0.2–0.4 percent to the annual growth in advanced Europe (IMF, 2007a). Another factor is the integration of production chains across East and West, often among different plants of the same group. This has helped many Western European companies to maintain their competitiveness on global markets despite mounting competition.

B. EU Membership and Macroeconomic Stability

Maastricht Criteria

One way of measuring NMS performance in the area of macroeconomic stability is to assess their performance vis-à-vis the Maastricht criteria.13 The criteria provide a relatively narrow assessment, focused on nominal convergence. Nonetheless, the NMS are expected to gear their policies toward fulfilling these criteria, as preconditions for joining the European Monetary Union (EMU). Even though there are no legal limits on how long an NMS can stay outside the euro area (and except for the excessive deficit procedure under the fiscal criterion, there are no sanctions for not satisfying the criteria), the NMS have committed to joining EMU if and when they satisfy the entry preconditions (unlike Denmark and the U.K.). Despite its limitations, it is therefore a useful yardstick for assessing performance in the area of macroeconomic stability.

Overall, on each of the five numerical Maastricht criteria, the NMS have performed better than the non-EU emerging market countries (Figure 3). The percentage of observations in which the respective criterion was missed was lower in the NMS than in other emerging market countries (OEM). The OEM countries are of course included only to put the NMS performance in a broader perspective, as the Maastricht criteria do not apply to them. While proving a causal relationship is very difficult, this supports the hypothesis that being in the EU is associated with better policy outcomes in terms of macroeconomic stability.

Figure 3.
Figure 3.

Performance vis-à-vis Maastricht Criteria, 2004–08

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Sources: Eurostat, national statistical offices, IMF staff estimates.
Figure 4.
Figure 4.

NMS: Export Share in the World Market, 2000–07

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: IMF, Direction of Trade Statistics.
Figure 5.
Figure 5.

Europe: Market Indicators in the Crisis

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Most NMS already comply with at least some of the Maastricht criteria, but meeting all of them consistently has proven to be a challenge (bottom part of Figure 3). Nonetheless, two NMS countries, Slovenia and Slovakia, have been able to satisfy the criteria and enter the euro area (Box 2).14

Price Stability

The period of EU accession and EU entry has been marked by improved price stability in the NMS. The NMS have been relatively successful in bringing inflation down and keeping it under control, with consumer inflation being lower, on average, than in other emerging markets (text chart). However, some of the NMS experienced credit-driven booms accompanied by accelerating price increases in the mid-2000s. Reflecting the difficulties in controlling inflation in these countries, the NMS have met the inflation criterion only about 40 percent of the time (Figure 3).


GDP per Capita and Inflation

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Sources: Eurostat; National Statistical Offices; and IMF staff estimates.

To some extent, the relatively higher inflation in the NMS can be explained by higher productivity growth. As productivity in the NMS converges with that in the OMS, wages and prices of non-traded goods and services rise (Balassa-Samuelson effect). This results in higher inflation, but without loss of competitiveness (text charts). Productivity differentials seem to explain from 0 to 3½ percentage points of annual inflation differentials in the NMS vis-à-vis the euro area, with most estimates clustered around 1–2 percent (IMF, 2007b).



Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: IMF’s World Economic Outlook, authors’ calculations.

The inflation performance of the NMS has also been affected by global price shocks. Inflation rates spiked up across the region (and around the world) in late 2007 and 2008, driven by rapid growth in food, oil, and other commodity prices. As these and related products make up a comparatively large part of their consumption baskets, the NMS saw their inflation rates being affected to a greater extent. However, even in the euro area, year-on-year inflation went up and reached as high as 4 percent during 2008. The situation has since changed dramatically, though. Commodity prices started declining rapidly when the global financial crisis hit with full force in 2008, price pressures receded everywhere, and monetary policy has been loosened around the world, including in the NMS.

Another factor potentially influencing inflation performance may by the countries’ choice of exchange rate regime: in 2004–08, the average annual consumer price inflation in NMS with hard pegs was 2.7 percentage points higher than in other NMS, as upward price pressures caused by capital inflows could not be absorbed through exchange rate appreciation.

To analyze the inflation performance of the NMS more formally, an econometric model was estimated on world-wide panel data for 1999–2008, trying to extract the impact of the country being a NMS (captured by a dummy variable equaling 1 for NMS and 0 for all other countries), adjusting for global factors (change in a commodity price index), and a range of country specific factors, capturing the choice of exchange rate regime (hard peg or other) and monetary policy regime (explicit inflation targeting or other), the degree of central bank independence, the country’s income per capita, and its previous inflation performance. The results (Table 3(i)) show the NMS membership dummy having the expected negative sign (suggesting relatively lower inflation in the NMS), but the estimated parameter is insignificant. The exchange rate regime and monetary policy regime dummies and the central bank independence index also have the expected signs, but are insignificant. The significant explanatory variables are the global commodity price index, the past inflation values, and the country’s level of GDP per capita. The bottom line from the estimate is that the relatively better performance of the NMS compared to the other emerging markets can be explained to a large extent by factors such as their relatively higher income per capita levels; their EU membership seems to be associated with somewhat lower inflation, but this is not significant.

As an alternative approach to analyzing inflation performance in the NMS, a logistic probability model was estimated, explaining the probability of satisfying the Maastricht inflation criterion as a function of a range of country characteristics and external shocks. Let Yit denote a dummy variable that takes the value of 1 when country i meets the Maastricht criterion in t and 0 otherwise. The probability of Yit=1 is estimated as a function of a range of explanatory variables Xit. Assuming that F(β’ Xit) is the cumulative probability distribution function evaluated at β’ Xit, where β is a vector of coefficients to be estimated, the likelihood function of the model is:15

log L=t=1Ti=1NYitlog[F(βXij)]+(1Yit)log[1F(βXij)].(1)

The resulting estimates (Table 3(ii)) suggest that the existence of the Maastricht inflation criterion had an impact on inflation in the NMS. Even after controlling for other potential explanatory factors, such as the country’s level of economic development, degree of central bank independence, and its exchange rate regime, the NMS were more likely to meet the criterion than one could expect based on a broader sample of countries (the NMS dummy in the first two estimates is significantly positive). An interesting side result is that inflation targeting countries were more likely to meet the criterion (this result is highly significant, both for the broad sample and for the NMS sub-sample), while those with hard pegs were less likely to do so (this finding is stronger when the sample is constrained only to NMS countries). Countries with higher GDP per capita and higher degrees of central bank independence are more likely to satisfy the criterion, even though this result is significant only for the broader country sample (which has more substantial variation in these two variables). Among the NMS countries, interestingly, public support for the euro (European Commission, 2008) did not seem to have a significant direct impact on the fulfillment of this criterion. This could reflect some degree of reverse causality: higher inflation rates may tend to push public opinion toward favoring euro adoption.

The analysis summarized in Table 3(ii) focuses on factors explaining whether the criterion was satisfied or not; it does not analyze the cost of meeting the criterion. Product or labor market rigidities, for example, can contribute to high sacrifice ratio. To quantify the macroeconomic policy adjustment needed to prepare for participation in monetary union, Bulíř and Hurník (2006) have used a dynamic stochastic general equilibrium model that allows for a joint analysis of monetary and fiscal policies, finding that a decrease in inflation by 1 percentage point implies a loss in output that ranges from 0.5 percent in the Czech Republic and 0.8 percent in Poland and the Slovak Republic to 1.6 percent in the Baltic states and 4.0 percent in Hungary. Also, a 1 percent decrease in the fiscal deficit results in a ½ percent decrease in the level of GDP in 1 year and a 1/3 percent increase in the level of GDP over the 5-year horizon. The estimated sacrifice ratios for the NMS are broadly similar in other papers,16 and not substantially different from estimates for non-NMS emerging markets.

There is some evidence that markets view compliance with the Maastricht inflation criterion positively. Specifically, when the “halo effect” regressions (Table 2) include a dummy variable for compliance with the Maastricht inflation criterion, the estimated coefficient is significant and has the expected negative sign. This is even after controlling for the fact that low inflation rates in general are associated with lower sovereign spreads (in all countries, not just the EU members), so this impact seems associated with the Maastricht criterion on inflation.

Table 2.

Explaining Spreads on Sovereign Bonds

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Absolute value of t statistics in parenthesis.* significant at 5%, ** significant at 1%

Euro Area Accession: Experiences of Slovenia and Slovakia

In January 2007, Slovenia became the first NMS to adopt the euro. Favorable initial conditions and sound macroeconomic policies over the past decade have allowed Slovenia to sustain robust growth with small external imbalances and public debt while gradually lowering inflation and interest rates to euro area levels. PPP-based per capita income reached about 80 percent of the EU average in 2006, putting Slovenia on a par with Greece and above Portugal (IMF, 2007c).

Slovakia has become one of the strongest economic performers among the NMS. Growth has shifted to a higher gear, driven by productivity gains and buoyant exports (Figure 4). Slovakia entered ERM2 in November 2005, and a coalition government formed following June 2006 elections committed to adopting the euro in January 2009. Notwithstanding the government’s emphasis on higher social spending, the 2007–09 budget framework aimed at meeting the Maastricht fiscal deficit criterion in 2007 and achieving further fiscal consolidation thereafter (IMF, 2007d). Slovakia has met all the Maastricht criteria, and entered the euro area in January 2009.

Is there something that sets Slovenia and Slovakia apart from the rest of the NMS that can explain why these two countries were the first two euro adopters? It is difficult to boil this down to a single factor, since the two countries’ initial economic conditions were different, and they went through different adjustment paths. What obviously sets them apart is their willingness and ability to satisfy all the Maastricht criteria at the same time. That is no mean feat, as illustrated by the output loss calculations in IMF (2007b) and Bulíř and Hurník (2006). One underlying factor that likely played a role has been the high degree of political commitment to euro adoption in these two countries, which in turn reflected broad support for the euro among their populations. This has been particularly the case in Slovenia, which has been recording the highest levels of support for the euro of all the EU countries (European Commission, 2008a). Slovakia has also been above the EU average in terms of public support for the euro, and its population has shown a remarkably high self-assessment of knowledge of the euro (European Commission, 2008b). This is not to say that high levels of public support or awareness automatically ensure euro adoption (in fact, the Eurobarometer survey appears only very weakly correlated with the likelihood of meeting the inflation criterion), but it can make the adjustments on the way to the euro more likely to succeed.

Fiscal Stability

General government balances in the NMS were generally worse than in other emerging markets, and also somewhat lower than in the OMS (text chart). Thus, the second most challenging Maastricht criterion for the NMS (after the inflation criterion) has been the fiscal deficit criterion, which the NMS have missed about 40 percent of the time (Figure 3).

There has been substantial cross-country variation, however, with the average 2004–08 general government balance varying from +1.6 to -6.5 percent of GDP in individual NMS.

Source: International Financial Statistics, authors’ calculations.

In NMS with subpar fiscal performance, the EU institutions have provided a framework within which to address this issue. Empirical analyses for the “old Europe” suggest that the Maastricht fiscal criterion, and its implementation through the SGP17 provides a rules-based framework that can be effective in combating politically-motivated fiscal policy distortions (Annett, 2006). These analyses suggest that the SGP has been successful in contributing to fiscal discipline in particular in smaller OMS with more volatile output (e.g., Austria, Belgium, Denmark, Finland, Ireland, the Netherlands, Spain, and Sweden). The 3 percent anchor appears crucial in anchoring expectations and monitoring (Schuknecht, 2004).

To examine the fiscal performance in more detail, the empirical estimate of Annett (2006) is replicated here for the NMS economies, for two periods (before and after the EU entry). Specifically, the following equation has been estimated:


where b is the fiscal balance, d is debt, y is the output gap, p is a dummy for the election year, g is a dummy for the form of fiscal governance, s the economy’s size, σ is its economic volatility, n is a dummy variable for new member states, ε is an error term, i and t denote country and year, respectively, and βs are the estimated coefficients.

The econometric estimates (Table 4) suggest that the SGP has more of an impact in the NMS countries, for several reasons. First, the economic size of these countries is far below the EU average, and the estimates (for both OMS and NMS) suggest that smaller size makes countries more amenable to external influences over fiscal policy. Second, economic growth in the NMS has been relatively more volatile (the standard deviation of growth over the past 10 years being twice that of the OMS, even though this may be biased upward by the structural adjustment in these countries), and the estimates suggest that countries with higher growth volatility are more likely to follow the fiscal rules. Third, most of the NMS rely predominantly on fiscal commitment, which, according to the estimates, makes them more amenable to comply with the SGP rules.18

Table 3.

Explaining Inflation Performance

(i) Dependent Variable: Average Annual Inflation (OLS estimate)

* significant at 10 %, ** significant at 5 %, *** significant at 1 %

On a scale from 0 (no independence) to 100 (full independence). Based on Arnone and others (2006).

2/ On a scale from 0 (no support) to 100 (full support). Based on European Commission (2008).

(ii) Dependent Variable: Compliance with the Maastricht Inflation Criterion (Logit estimate)

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* significant at 10 %, ** significant at 5 %, *** significant at 1 %

On a scale from 0 (no independence) to 100 (full independence). Based on Arnone and others (2006).

On a scale from 0 (no support) to 100 (full support). Based on European Commission (2008).

Table 4.

Fiscal Policy Behavior in NMS and OMS Before and After SGP (Dependent variable: cyclically-adjusted primary balance 1/)

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Source: authors’ calculations.

Robust standard errors in parentheses; 2SLS estimation. OMS estimates are an update of Annett (2006).

***= t-statistic significant at 1 percent level; **= t-statistic significant at 5 percent level; *= t-statistic significant at 10 percent level.

Relatedly, countries that follow the fiscal rules more closely are likely to see lower bond spreads. This is consistent with the findings of Debrun and Joshi (2008), who analyze fiscal rules in EU countries, finding that introducing numerical fiscal rules (or tightening existing ones) tends to reduce yields on long-term government securities, either through a “pure” credibility effect, or through an induced improvement in fiscal indicators (cyclically adjusted primary balance and public debt). The credibility effect is more likely to be found in countries with a stronger record of good fiscal behavior and with budgetary procedures more conducive to an effective implementation of numerical fiscal rules.

C. EU Membership and Structural Policies19

In the area of structural policies, a key part of the EU framework is the Lisbon Agenda. Launched by the European Council in Lisbon in 2000, it set forward a broad set of structural reform objectives, notably increasing the employment rate from 61 percent to 70 percent by 2010 (20 million extra jobs), and raising growth to an average real rate of 3 percent. The agenda is based on an “open method of coordination,” which eschews centralization of policy formulation, and initially focused on benchmarking based on quantitative and qualitative indicators and specific timetables. Important components of the agenda are annually updated National Reform Programs,20 and an annual monitoring of progress by the EU Council.

The Lisbon agenda is a potentially useful vehicle for coordinating structural reforms, but so far the progress under the agenda has been uneven (e.g., IMF, 2008). For the EU as a whole, significant progress towards the Lisbon targets has been made, but these are now being threatened by the financial crisis and further efforts are needed. The employment rate, for example, has risen across the EU since 2000, but is turning now. All along, joblessness among the young has remained far too high. Access to secondary education has improved, but too many children still do not complete secondary education. The effective retirement age has increased across the EU, but it is still below 60 in a third of EU countries. This slow progress has lead some to question whether the program has influenced national reform programs (Centre for European Reform, 2008)

Debrun and Annett (2004) found some evidence that within the EU, smaller countries are more reformist. They measure progress on structural reforms by an index built on data on regulatory restrictions collected by the OECD, and combining it with the Social reforms database compiled by the Fondazione Rodolfo DeBenedetti. Reviewing the Lisbon strategy’s “open method of coordination,” they conclude that the method has not lived up to expectations, but remains appropriate given the EU’s overall governance architecture, especially in the area of labor market reforms that are largely in the realm of national decision-making. They propose improving the open method by focusing on labor participation; greater use of “naming and shaming”; further progress on product market reforms; and more leadership on structural reforms by large countries.

After a thorough evaluation led by former Dutch Prime Minister Wim Kok, the Lisbon Agenda was relaunched in 2005. The focus was shifted from quantitative targets to specific policy actions, labor market reforms were given priority, and “naming and shaming” was downplayed.21

To examine the impact of the re-launched Lisbon agenda on structural policies, including in the NMS, we have updated the analysis by Debrun and Annett (2004). The results suggest that the factors explaining the likelihood of reform in the NMS are not fundamentally different from those explaining the performance of the OMS and non-EU OECD countries (Table 5).22 For example, even for the NMS one finds that smaller countries tend to be more reformist. Also, the countries with better fiscal performance tend to perform better on structural reforms.23 This highlights the central role played by fiscal policy in these countries, and an additional possible beneficial effect of the EU framework acquired by accession.

Table 5.

Explaining Structural Reforms

(Dependent variable: change in the relevant structural index times 100)

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Note: Both equations were estimated using a feasible GLS estimator allowing for cross-section heteroskedastic and contemporaneously correlated errors (SUR). Significance levels are based on robust standard errors. Superscripts *, **, and *** indicate that the estimated coefficient is significantly different from zero at the 10, 5, and 1 percent level, respectively. The labor equation includes two lags of the dependent variable while the product market equation includes one lag of the dependent variable (not reported). All equations include country fixed effects (not reported).1/ Coefficients of the EU membership dummy interacted with the corresponding explanatory variable.2/ Significance levels based on Wald test that the sum of both coefficients is equal to zero.

As regards labor market developments in NMS, faster-reforming countries have had better unemployment records and have been best placed to experience job-creating growth (e.g., Schiff and others, 2006). This points to the need to complete the structural reform process and remove the remaining bottlenecks that have hindered faster reallocation of resources and reduced unemployment. Labor market policies have some, but not a dominant, influence over labor market outcomes. It appears that those countries with more flexible policies are better able to take advantage of positive macroeconomic shocks with higher employment and lower unemployment rates.

Labor markets in the NMS are more flexible than those in the OMS, but less flexible than those in non-EU emerging markets. Measures of labor market flexibility provide comfort that the NMS are in general relatively well positioned to adjust to shocks. Compared to the OMS, employment protection legislation in the NMS is less restrictive, minimum wages are lower, collective bargaining structures are less centralized, and unemployment benefits are less generous (Boeri and Garibaldi, 2006). However, the same is true in reverse when the NMS are compared with non-EU emerging markets. Also, there is variation in labor market flexibility across the NMS, with wages being more responsive to productivity and unemployment in the Baltic countries than in the Central European NMS (von Hagen and Traistaru-Siedschlag, 2006).


NMS, Euro Area and Other OECD Countries: Business Regulations, 2001 1/

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: OECD.1/ Sorted by 2004 values. The scale of indicators is 1-10 from most to least regulated; Euro area (simple average).

In the EU as a whole, goods markets are relatively well integrated, but the internal market in services remains rather fragmented. This has been reflected in particularly sluggish productivity growth in services (IMF, 2008). Competition in the network industries (such as telecoms and energy) is uneven, with incumbents continuing to dominate national markets. Progress at national level has been equally inconsistent. As a result, there are still marked variations between the best- and worst-performing countries. In the NMS, product markets are relatively tighter than in the OMS, and business regulations tend to be more onerous (text chart). For example, in many of the NMS, there is still virtually no competition in the telecom market. Many of the new members are further from the technological frontier than the major OMS economies. However, at their stage of development, they are still well-placed to adopt technologies developed elsewhere to drive productivity growth. In many of the new member-states, quasi-monopolies still import, transport and distribute all natural gas. This underscores the importance of the Services Directive. Judicious and, where possible, accelerated implementation of this Directive, which should be fully implemented by end-2009, should benefit the NMS and help them catch up with the OMS.

The bottom line from this analysis is that the Lisbon agenda seems to have had a relatively larger impact on structural policies in the NMS. In some of the “old” EU member states (especially the larger ones), the soft targets of the EU’s reform agenda do not seem to have done much to spur governments into action. But in small countries and in many of the NMS, governments have discussed their Lisbon-related ‘national reform programs (NRPs) in their respective parliaments, as well as with trade unions, business federations and other parts of civil society. Some of these countries only developed innovation and research policies as a result of the Lisbon process.

What has been the effect of structural policies on economic developments in individual NMS? There is an extensive literature on positive long-term effects of structural reforms (e.g., Tressel, 2008). An interesting, and more controversial, question is whether the reforms had an impact on economic developments in the NMS during the recent crisis. Interestingly, the NMS countries that have so far seen the largest increases in spreads during the crisis (e.g., some of the Baltics) scored highly on structural indicators, such as the World Bank’s Ease of Doing Business Rank, while the countries that have so far been the least effected (in particular, Slovenia, Czech Republic, and Poland) had relatively lower scores on those rankings. This illustrates the fact that the size of the macroeconomic and financial imbalances prior to the crisis may be more important than the extent to which countries had pressed ahead with reforms. A full examination of this topic would go beyond the scope of this paper.

D. EU Membership, Financial Integration, and Financial Stability

The financial sector has played an important role in the NMS’s rapid economic convergence. EU membership has had a major impact on financial sector policies in the NMS, along two main dimensions: financial integration policies and financial stability arrangements. These dimensions are intertwined, as closer cross-border financial integration necessitates closer cross-border integration of financial stability arrangements.

Source: Authors’ calculations based on data from International Financial Statistics and ©2003 Bureau van Dijk Electronic Publishing-BankScope.

The integration process between new and old member states started well before the former’s EU accession, as they revamped their regulatory and supervisory systems in line with EU standards, removed capital account restrictions, and saw financial institutions from the old member states become major players in their home markets, partly in anticipation of EU membership. It has continued unabated since then, as accession further reduced the impediments to financial integration. One measure of the degree of integration is the share of foreign-controlled banking assets, which has increased substantially in the NMS, and is higher than in the rest of the world (text chart).24

While this process unfolded, the old member states went through a historic period of financial integration among themselves. The driving forces were monetary union (1999) and the Financial Services Action Plan (1999–2005).25 This Plan aimed to modernize and harmonize the regulatory framework for the financial sector, in the realization that this was a necessary precondition for monetary union to result in a single financial market. Cornerstones of the Plan were the Capital Requirements Directive (CRD), the Solvency II Directive, and the Markets in Financial Instruments Directive (MiFID), which aimed to overhaul regulation for respectively the banking, insurance, and securities sectors. While the CRD and MiFID are now in effect, discussions continue with respect to Solvency II.

The challenges encountered in realizing the Financial Services Action Plan and ensuring consistency in implementation across countries gave birth to the Lamfalussy framework, which was proposed in 2001 by a group of wise men chaired by Alexandre Lamfalussy.26 This framework aims to facilitate financial sector rule making at the EU level, allow for quicker adjustments in those rules when the need arises, and achieve a more consistent application of these rules at the national level. The so-called Level 3 Committees of the Lamfalussy framework27 bring together the national supervisors, and have been tasked with much of the burden of achieving the desired convergence. The December 2007 ECOFIN launched a road map of reforms to reinforce these committees.28

EU membership and financial sector soundness in the NMS

Five years after EU entry, the bottom line assessment of financial sector soundness in the NMS is mixed. In many respects, the banking systems of the NMS have held up relatively well so far in the global financial crisis. There have been no systemic failures, no generalized loss of depositor confidence, and no breakdown of essential financial functions. Nonetheless, the outlook is challenging. This reflects the considerable risks (with real and financial risks being interlinked) that have developed in the NMS in recent years. These risks are becoming more acute and are partially materializing due to the global financial crisis. Financial integration has contributed to the build-up of risks by loosening financial constraints, triggering capital inflows, credit growth, and asset price increases, which in turn allowed rapid growth in domestic demand. A particular source of risk in some of the NMS countries is that the rapid credit growth has been accompanied by a growing share of loans denominated in foreign currencies (text chart). The main underlying risk is that credit may have been extended too quickly, without sufficient risk assessment, and insufficiently taking into account the potential for risk correlation due to macroeconomic developments. Potential adverse outcomes of such a risk build-up at the macro level are overheating, loss of competitiveness, scenarios of prolonged sluggish growth, shocks to expectations and income growth, “sudden stops”, interest rate and exchange rate instability, and asset price corrections. At the time of writing, some of these outcomes were materializing.


Foreign Currency-Denominated Loans, 2005

(in percent of total outstanding loans)

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: National authorities, Fund staff estimates.Note: Regional averages for East Asia and Latin America cover emerging market countries.

The basic financial soundness indicators paint a mixed picture of the financial health of the NMS banks over the last five years (Table 8). On the positive side, these banks have been highly profitable, booking returns on assets and equity that exceed not only those in advanced economies, but also in other emerging markets. Also, their nonperforming loan ratios have been below other emerging markets, and declining over time. However, both the profitability measures and the nonperforming loan ratios had been propped up by the rapid growth of loans and are bound to worsen substantially as the crisis affects loan performance and banks’ revenues. Unfortunately, the NMS banks are on average less capitalized than their emerging market counterparts, and there is evidence that relatively weak banks have expanded fast (Tamirisa and Igan, 2008). An important issue in this context will be the willingness and ability of the banks’ owners (mostly OMS banks) to inject additional capital when needed and sustain the intra-group credit lines on which many depend (Aydın, 2008).

Market-based indicators of financial sector soundness suggest that the health of NMS banks has become rather closely correlated to the health of the OMS banks.29 This reflects the closer integration between the NMS and OMS banking systems, as well as the impact of tightening global conditions on both groups of banks.30 They both appeared to have been doing relatively well around 2005, but the global financial crisis, combined with the uncertainties about some of the domestic risks, has brought their distance to default measures close to or even below zero in late 2008 and early 2009 (text chart).

Underlying this aggregate assessment for the NMS as a whole are important cross-country differences in bank soundness. This can be seen in the financial soundness indicators (Table 8) and in the cross-country dispersion of market-based indicators such as the distance to default measures.

EU membership and prudential regulation in the NMS

Domestic financial stability arrangements in the NMS have been to a large extent influenced by EU policies and directives. EU membership has implied adoption of the EU’s regulatory framework, including the Capital Requirements Directive and the other Directives adopted under the Financial Services Action Plan (see above).


Distance to default for portfollos of banks

Citation: IMF Working Papers 2009, 068; 10.5089/9781451872156.001.A001

Source: BankScope, Bloomberg, authors’ calculations.

This has led to improved regulation and supervision. An analysis of the IMF’s assessments of regulatory and supervisory quality in individual EU countries (Box 3 and Table 7) suggests that regulatory and supervisory frameworks in the NMS countries were of higher quality than those in comparable non-EU emerging markets (especially in the areas of insurance and securities regulation), which can be attributed to the harmonization of the regulatory frameworks in the EU. Within the EU, regulation and supervision in the OMS countries were of significantly higher and more even quality than that in the NMS. (However, supervision in the OMS also faces more complex financial systems, and the global financial crisis that started in 2007 exposed significant inadequacies in the supervisory systems of at least some high-income countries relative to the complexity of their financial systems). The analysis suggests that financial supervisory systems in the NMS are generally of high quality but need to evolve further to close remaining gaps and meet new challenges.

Table 6.

Lisbon Scorecards

(Ranking; 1=best performer, 27=worst performer)

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Source: Centre for European Reform.
Table 7.

Prudential Supervision in NMS and Other Countries 1/

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Source: Financial sector standards and codes assessments under the FSAP.Notes:

For each country, the summary grading of a standard (BCP, ICP, and IOSCO) is calculated as the average grading of the principles in the standard. For each principle, 100 is the maximum grading (observance), and 0 is the minimum grading (no observance). For the definitions of the four components of each summary grading, see Table 6.

Calculated across the countries in the sample.

The value for the EU countries minus the value for the non-EU countries.

Indicates that the difference is significant at a 10 percent level in tests of equality of means and variance, respectively.

Table 8.

Financial Soundness Indicators in NMS and Other Countries

(In percent)

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Sources: National authorities; and IMF staff estimates (Global Financial Stability Report October 2008).Note: Due to differences in national accounting, taxation, and supervisory regimes, FSI data are not strictly comparable across countries.