Abstract
This Selected Issues and Statistical Appendix paper assesses Romania’s external competitiveness by reviewing recent developments in a range of standard indicators and estimating equilibrium real exchange rates. The results suggest that, although Romania’s historical cost advantage vis-à-vis trading partners has eroded since end-2004, on account of a strong real exchange rate appreciation, some undervaluation still remains. Furthermore, evidence suggests that the recent weak output and export performance in some of the traditional exporting sectors mainly reflects the transition toward higher value-added products.
III. Real Convergence Prospects12
Ten myths of transition?
Higher real incomes are seen as the key goal of European Accession. However, the “catching-up” process has been slower than many thought, and Romania is now experiencing many of the pressures seen earlier in the new member states that joined the European Union in 2004. Policymakers have been tempted to see the growing macroeconomic imbalances as a natural part of the convergence process rather than a result of weak economic management. However, the experience of the early accession states suggests that while transition may bring its own problems, the principles of sound economic management cannot be set aside. This paper looks at ten commonly held views or “myths” about the convergence process that may have “colored” economic thinking and policy in Romania.
65. Over the past decade, the states acceding to the European Union have made considerable progress in the transition to competitive market economies. However, even in the new member states (NMS) real income levels remain well below those of the original 15 members of the European Union. The rate of convergence has been affected by many country-specific factors but, in most countries, common features of the transition have been consumption booms financed by rapid credit growth, a sharp take-off of investment, strong real appreciation driven by capital inflows, and widening current account deficits. Many policy makers in central and eastern Europe countries have seen these pressures as a reflection of the strength of the transition process, and the pull of the European Union, rather than the growth of unsustainable imbalances between investment and national savings. On the other hand, the experience of the transition states does not appear to be that different from growth spurts seen in other emerging market economies. The patterns are similar to the rapid expansion in Brazil that followed the “Real Plan” and preceded the 1998 financial crisis, or the investment and consumption boom that led up to the Mexican peso crisis of 1994. The experience of the early accession states (Greece, Ireland, Portugal, and Spain) cautions against overstating the impact of accession. The catch-up process in these countries took a long time and stable macroeconomic policies were key for fostering sustained economic growth.
66. Romania and Bulgaria initially lagged the earlier accession states but are now experiencing many of the same trends, with strong consumption and investment growth and widening external imbalances. The proximity of EU accession, privatization and structural reforms, the setting up of functioning markets and progress in macroeconomic stabilization have been crucial for this. A common view is that the widening macroeconomic deficits reflect the impact of these structural changes. The macroeconomic imbalances are “nothing to worry about” and the inflow of capital and investment will justify the surge in spending, with rapid economic growth bringing about the anticipated improvement in incomes. Another, more cautious view, is that these imbalances are a reflection of a transition process that has not always been well-managed, that the catch-up process cannot be achieved by one-off spurts in growth rates, and that failure to adequately address growing current account deficits will raise the balance of risks for these economies. A comparison of the experience of Romania with that of the NMS helps to provide some perspective on where the country stands in terms of convergence as well as the management of the transition to EU membership.
Myth 1: EU accession will lead to a rapid improvement in incomes?
One of the lessons of past accessions is that the “catch-up” takes a long-time and will continue well after accession. Transition does not somehow prevent the risk of “stop-go” boom and bust. Sustained macroeconomic policies are needed to achieve real convergence.
67. The transition experience of the 10 new member states of the European Union has been too short to make an assessment of the speed of the catch-up process, with the overall trends heavily influenced by short-term macroeconomic developments. Previous accessions (Greece, Ireland, Portugal, and Spain) are not directly comparable as the starting conditions and economic structures were different from central and eastern Europe. Nevertheless, income levels in the four countries were well below the EU average at the time of accession, and have shown a significant catching-up (Figure 1). The convergence process for these countries took many years with the GDP per capita of Portugal, the best performer, gaining 17 percentage points compared with the EU average only 10 years after accession. In the case of Greece, relative income levels actually fell initially, suggesting that overall macroeconomic performance is an important determinant of sustained real income growth. In Ireland, the rapid acceleration in real incomes came later, many years after accession.
68. The experience of these countries suggests that Romania, which has a much lower real income level, faces a “marathon” rather than a short “sprint” in its convergence to EU living standards. Narrowing the gap in incomes is obviously seen by the authorities as an important goal in its own right and as an element for reinforcing the population’s ownership of often harsh reforms. However, raising hopes of quick gains in per capita incomes may be self-defeating as the population may be encouraged to spend beyond its means, resulting in higher consumer indebtedness and an unsustainable boom in consumption. Arguments that large public sector wage hikes as seen in 2004 and 2005 are needed to “catch-up” should therefore be treated with caution. Unrealistic expectations of rapid income growth from EU accession will only fuel demand pressures and increase the risk of “stop-go” development.
Catch-up: Previous Accessions
(10 years after accession)
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Catch-up: Previous Accessions
(10 years after accession)
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Catch-up: Previous Accessions
(10 years after accession)
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Myth 2: The EU is the appropriate “benchmark” for economic and structural policies for Romania and accession will of itself lead to rapid growth in real incomes?
The experience of the NMS has been mixed, and weaker than that of many other emerging markets. The pull of EU accession can only do so much, with performance depending on the strength of reforms and overall macroeconomic policies.
69. EU accession has been important in promoting reforms, but should not be seen as a panacea. Over the last decade, the NMS have made considerable progress in establishing competitive market economies and macroeconomic stabilization. However, despite difficult structural reforms, living standards have been slow to catch-up, with markedly different performance among the group.
70. The Romanian economy is thought to be comparable in structure with the larger new member states such as Poland, Hungary and the Czech Republic. It is interesting that while these NMS have made headway compared with the Euro area, their purchasing power as a share of world GDP has been static or even declining (Figure 2). The explanation is the weaker performance of the Euro area and the much more rapid growth of other emerging markets. The transition process for the acceding states has naturally been EU centric, but Romania may be well advised to look at how it is performing relative to other more dynamic emerging economies as, ultimately, real income growth will depend on success in building competitive markets and structural reforms. Many important areas such as labor market reform and macroeconomic policy are not touched by the EU acquis, and Romania should be aware that it is joining an economic bloc that has been held back by slow progress in key structural reforms. While EU accession has given Romania an important boost, the future pace of convergence will depend more on the vigor with which structural reforms are pursued in Romania and on its own macroeconomic performance than on accession. Indeed, recovery in real incomes in Romania only started in the early 2000s when more stable macroeconomic policies took hold.
Percentage change in GDP per capita, 1994-2005 Percent of world GDP per capita, PPP terms
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Percentage change in GDP per capita, 1994-2005 Percent of world GDP per capita, PPP terms
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Percentage change in GDP per capita, 1994-2005 Percent of world GDP per capita, PPP terms
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Myth 3: Consumption booms in transition countries are the result of “optimal” decisions by individuals about higher future incomes?
Data on real income convergence suggest that booms may be partly the result of overly optimistic assumptions about the impact of EU entry. The boom in consumption has been sharper in Romania, a late starter, than many other NMS.
71. The experience of many emerging markets suggests that strong GDP growth leads to expectations of higher incomes and a boom in private consumption (lower private savings). Such a boom in consumption is likely to be higher when households are not constrained from borrowing and the liberalization of the capital account leads to greater liquidity. Generally, current account imbalances resulting from increased consumption are less likely to be sustainable than deficits resulting from higher investment, as investment is expected to lead to future export growth. Detractors argue that “permanent income” decisions by consumers are “optimal” given the prospect of higher future earnings, and that the decline in private savings will be transitory and should recover when future incomes improve.
72. Not surprisingly, the experience of many countries that had high growth rates and consumption booms, such as Chile in 1979-81, does not bear out such optimism. In the case of Chile, overly optimistic expectations about future growth and incomes, combined with a loosening of liquidity constraints from capital account liberalization, resulted in a crisis despite a strong fiscal position.
73. The experience of the NMS has been mixed over time and is difficult to generalize as a “boom” with savings falling in some countries and increasing in others (Figure 3). In Hungary, strong growth in the mid-1990s was actually accompanied by higher household savings with the current account improving. Subsequently, savings deteriorated in the period 2001-2005, complicating demand management. Poland also saw an improvement in savings during the boom in the mid-1990s, with much of the deterioration of the current account in 1997-1999 due to higher investment. After a fall in savings and investment in the 2000 period there has been some recovery. In the Czech Republic, there was a fall in savings during the mid-1990s boom followed by a recovery and some recent slippage in 2003-2004. In comparison, the decline of savings by 4 percentage points of GDP in Romania since 2002 has been comparatively sharp. The strong consumption boom has also appeared at a relatively early stage in the economic recovery before the impact of stronger investment has taken hold. Hilbers and others (2005) have compared crisis and noncrisis countries facing consumption booms financed by rapid credit growth (Figure 4). The analysis indicates that those countries that were not able to moderate consumption growth before credit peaked were more likely to face crisis, suggesting a more proactive role for demand management policies.
Percentage change in Gross Private Savings, 1994-2005
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Percentage change in Gross Private Savings, 1994-2005
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Percentage change in Gross Private Savings, 1994-2005
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Private Consumption during Credit Booms
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Source: Hilbers and others (2005)Private Consumption during Credit Booms
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Source: Hilbers and others (2005)Private Consumption during Credit Booms
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Source: Hilbers and others (2005)Myth 4: Credit booms in transition economies reflect low financial intermediation and will correct themselves?
Evidence from the NMS suggests credit booms are linked to the level of financial intermediation, but recent work has raised the question of “how fast is too fast.” Experience elsewhere suggests that perceptions about the stability of the policy stance are important in determining whether a boom will end in a soft or hard landing, regardless of the degree of financial intermediation.
74. Strong consumption growth in central and eastern Europe has been partly financed by rapid increases in bank credit to the private sector. In the past few years, real growth rates of credit to the private sector (both business and households) were often in the range of 30-50 percent a year. Improved household confidence has come at a time when bank privatization, competition by banks for market share prior to EU entry, and diminishing opportunities for attractive asset placements elsewhere have increased banks willingness to lend to the region. The degree of initial financial intermediation differed considerably between the accession countries, with bank credit to the private sector at over 50 percent of GDP in 2000 in the Slovak Republic and below 5 percent in Albania. Figure 5 shows that the fastest rates of real credit growth since 2000 have been associated with the lowest levels of financial intermediation, providing support for the “catching-up” hypothesis. The level of financial intermediation has been closely associated with the level of direct investment. Countries with the highest financial intermediation like the Czech and Slovak Republics have also shown the highest levels of investment. On this basis, it has often been argued that credit booms are a natural part of real convergence, promoting growth, and will slow of their own accord as the “equilibrium credit to GDP ratio” is reached.13
Financial Depth and Real Growth of Credit
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Financial Depth and Real Growth of Credit
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Financial Depth and Real Growth of Credit
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
75. Obviously, successful real convergence depends not only on the size and efficiency of financial intermediation but also on potential macroeconomic and prudential risks. Both Romania and Bulgaria experienced a decline in private sector credit in the late 1990s reflecting bank sector restructuring, with bank lending to the private sector falling to 15 percent of GDP in Bulgaria and 7 percent in Romania. In the last 2 to 3 years, both countries have experienced credit booms raising the question of “how fast is too fast.” Duenwald, Gueorguiev and Schaechter (2005) argue that the credit booms in both countries have contributed importantly to widening macroeconomic imbalances and heightened external vulnerabilities. Hilbers and others (2005) stress that, notwithstanding the initial level of financial intermediation or rates of GDP growth, about three-fourths of credit booms have been associated with a banking crisis and almost seven-eighths with a currency crisis.
76. The experience of the NMS does not suggest that credit growth will automatically slow. On average, credit booms in the NMS have lasted about 6 years suggesting that Romania may face continuing pressures even following EU accession. While credit to GDP ratios in Poland and Czech Republic have fallen slightly over 2002-2004, Hungary and the Baltics continue to show high average annual increases. Interestingly, Hilbers and others (2005) show that credit booms are still ongoing in the early EU accession states, suggesting that they can be sustained over time if accompanied by the right policies (Table 1). Even in crisis countries, booms have been sustained for many years until the crisis hit often due to a change in sentiment about the sustainability of the policy stance. This suggests that expectations are important and that prudent macroeconomic and financial policies will be crucial if Romania is to maintain macroeconomic stability during what is likely to be a lengthy transition process. When credit growth is rapid it is often difficult to disentangle macro risks from prudential ones, with deterioration in prudential indicators often a lagging indicator of a crisis. A prudent macroeconomic stance is therefore important to help limit the scope for a slippage in credit quality.
Bank Credit to the Private Sector during Credit Booms
Bank Credit to the Private Sector during Credit Booms
| Start of boom | End of boom | Duration | |
|---|---|---|---|
| Crisis countries | |||
| Argentina | 1990 | 1995 | 6 |
| Brazil | 1993 | 1998 | 6 |
| Mexico | 1987 | 1994 | 8 |
| Philippines | 1988 | 1998 | 11 |
| Uruguay | 1992 | 2002 | 11 |
| Ecuador | 1993 | 1999 | 7 |
| Early EU accession countries | |||
| Greece | 1995 | ongoing | 9 |
| Ireland | 1995 | ongoing | 9 |
| Portugal | 1987 | ongoing | 17 |
| Spain | 1998 | ongoing | 6 |
| NMS and acceding countries | |||
| Hungary | 1994 | ongoing | 10 |
| Latvia | 1997 | ongoing | 7 |
| Lithuania | 1998 | ongoing | 6 |
| Romania | 2003 | ongoing | 3 |
| Bulgaria | 1998 | ongoing | 6 |
Bank Credit to the Private Sector during Credit Booms
| Start of boom | End of boom | Duration | |
|---|---|---|---|
| Crisis countries | |||
| Argentina | 1990 | 1995 | 6 |
| Brazil | 1993 | 1998 | 6 |
| Mexico | 1987 | 1994 | 8 |
| Philippines | 1988 | 1998 | 11 |
| Uruguay | 1992 | 2002 | 11 |
| Ecuador | 1993 | 1999 | 7 |
| Early EU accession countries | |||
| Greece | 1995 | ongoing | 9 |
| Ireland | 1995 | ongoing | 9 |
| Portugal | 1987 | ongoing | 17 |
| Spain | 1998 | ongoing | 6 |
| NMS and acceding countries | |||
| Hungary | 1994 | ongoing | 10 |
| Latvia | 1997 | ongoing | 7 |
| Lithuania | 1998 | ongoing | 6 |
| Romania | 2003 | ongoing | 3 |
| Bulgaria | 1998 | ongoing | 6 |
Myth 5: Current account deficits are a normal part of transition?
All NMS experienced widening current account deficits. However, disciplined fiscal policies are critical to ensure domestic savings do not get too far out of line with investment. The financing of the deficits is likely to become more volatile over time as capital markets develop.
77. All the new member states posted sizable current account deficits, leading to the view that widening deficits are a natural part of the transition process. Convergence via a higher rate of investment is seen to require higher foreign savings given low private savings and weak financial sectors (Schadler and others (2006)). The financing of the current account deficits in the NMS was largely covered by inflows of FDI, portfolio investment being constrained by illiquid and inefficient capital markets. This benign view of growing current account imbalances rests heavily on an implied economic consistency that suggests that the financing of such deficits is sustainable over the longer-term given higher expected growth rates. Such a view rests heavily on the assumption that disciplined fiscal policies will not allow the domestic savings rate to diverge from the investment rate over time. Moreover, the assumption that FDI will continue to fund the deficits in a non-debt creating way becomes more questionable over time. The privatization process has slowed in most NMS, and the development of financial markets will stimulate the emergence of more volatile sources of funding such as portfolio investment.
Figure 6 compares the pattern of current account deficits and direct investment flows in Romania with that of Hungary, Poland, and the Czech Republic. Romania’s experience in terms of coverage of the current account deficit with direct investment is similar to in Poland and the Czech Republic in the early 2000s. Both these countries showed a sharp fall-off in direct investment prior to accession as investors had already established themselves in the local markets. It is to be noted that the fall in direct investment in Hungary and the Czech Republic was not associated with improved current account performance. Instead, there was a shift to potentially more volatile capital inflows, suggesting that widening imbalances can eventually lead to pressures on demand management policies, whatever the initial source of finance.
Current Account Balance and Direct Investment, net
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Current Account Balance and Direct Investment, net
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Current Account Balance and Direct Investment, net
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Myth 6: Current account deficits that reflect higher investment are not risky?
The experience of the NMS suggests that current account deficits resulting from investment are more sustainable than those based on consumption, but much depends on where the investment is going.
78. Transition countries running a high current account deficit because of high investment rates rather than consumption are regarded as less at risk (Zanghieri (2004)). High investment should lead to an improvement in the productive capacity of the country and potentially higher exports. The experience of the ten NMS states has differed considerably, suggesting that certain types of investment may be more sustainable than others. Investment rates in the Czech Republic did not translate into the same growth rates as in Poland, indicating that high investment does not automatically increase productive capacity. For example, investment in real estate financed from abroad may actually increase the risk of speculative “bubbles.” Moreover, FDI aimed at exploiting the domestic market will have different current account implications than FDI aimed at export and regional markets. FDI may even add to balance of payments pressures due to higher direct foreign borrowing, as many foreign-owned companies have easy access to foreign banks through their headquarter operations.
79. Romania and Bulgaria are increasingly expected to attract new investment with the prospect of EU accession imminent. However, the two countries have shown very different trends in the composition of the pick-up in domestic demand. In Romania, the initial pick-up in domestic demand from 2003 was largely driven by consumer spending, with gross domestic investment only increasing slightly from 21.8 percent of GDP in 2003 to 22.3 percent in 2004, and to 22.9 percent in 2005. In Bulgaria, domestic demand has largely been driven by investment with the rate of growth of investment nearly double that of consumption. A very rough indicator of the degree of investment activity is the share of machinery (excluding cars) in imports. This increased dramatically in Hungary in the second half of the 1990s from 24 percent in 1996 to 45 percent in 2004 (Table 2). The Czech Republic also registered a steady increase in the share of machinery imports, while Poland showed little change. The share of machinery in Romania’s imports increased in the late 1990s, but has actually fallen since 2000. This compares with a sharp pick-up in machinery imports in Bulgaria, albeit from a lower base. The pattern for Romania is consistent with the overall trends in investment, with much of the recent surge being driven by privatization, banking, retail and real estate. Greenfield investment is only beginning to take hold.
Imports of Machinery (excluding cars) Percent of total
Imports of Machinery (excluding cars) Percent of total
| 1996 | 2000 | 2004 | |
| Hungary | 23.6 | 43.4 | 44.5 |
| Czech Republic | 30.4 | 31.7 | 32.9 |
| Poland | 25.6 | 26.8 | 25.2 |
| Romania | 22.1 | 25.0 | 23.4 |
| Bulgaria | 12.6 | 16.9 | 18.5 |
| Lithuania | 16.1 | 15.8 | 19.3 |
Imports of Machinery (excluding cars) Percent of total
| 1996 | 2000 | 2004 | |
| Hungary | 23.6 | 43.4 | 44.5 |
| Czech Republic | 30.4 | 31.7 | 32.9 |
| Poland | 25.6 | 26.8 | 25.2 |
| Romania | 22.1 | 25.0 | 23.4 |
| Bulgaria | 12.6 | 16.9 | 18.5 |
| Lithuania | 16.1 | 15.8 | 19.3 |
Myth 7: Capital surges reflect high marginal productivity and are not a cause for concern?
The experience of the NMS suggests that achieving low inflation early is key to avoiding capital volatility.
80. Romania and Bulgaria are facing strong capital inflows following the liberalization of their capital accounts. Such flows are seen as intrinsic to the convergence process. However, the NMS responded to capital flows in different ways. Central banks face what has been coined by Lipschitz and others (2002) as the “Tosovsky Dilemma” after the former Czech National Bank Governor. If the monetary authority sets too high an interest rate reflecting the high marginal productivity of capital, foreign capital will pour into the country putting pressure on the exchange rate. On the other hand, if the monetary authority attempts to dampen these inflows by setting interest rates at a level below capital productivity they will depress saving below investment, fueling inflation and widening the current account deficit. Lipschitz and others (2002) illustrate the potential size of the inflows needed to equate the marginal productivity of capital assuming no risk premium and other obstacles to capital (Table 3). For Romania, with high capital scarcity, the marginal productivity of capital was estimated at 14 times that of Germany with a potential capital flow of over 600 percent of GDP. While these calculations are fairly simplistic they serve to highlight the potential magnitude of the problem facing the National Bank of Romania compared with its peers.
Capital Scarcity and Potential Capital Flows
In percent of German GDP per worker, average 1994-1999.
Cobb-Douglas production function.
In percent of pre-flow GDP.
Capital Scarcity and Potential Capital Flows
| GDP per worker 1/ | Relative marginal product of capital 2/ | Potential inflows 3/ | |
|---|---|---|---|
| Romania | 26.9 | 13.8 | 634 |
| Bulgaria | 22.9 | 19.1 | 753 |
| Czech Republic | 53.6 | 3.5 | 275 |
| Hungary | 55.7 | 3.2 | 259 |
| Poland | 38.6 | 6.7 | 425 |
In percent of German GDP per worker, average 1994-1999.
Cobb-Douglas production function.
In percent of pre-flow GDP.
Capital Scarcity and Potential Capital Flows
| GDP per worker 1/ | Relative marginal product of capital 2/ | Potential inflows 3/ | |
|---|---|---|---|
| Romania | 26.9 | 13.8 | 634 |
| Bulgaria | 22.9 | 19.1 | 753 |
| Czech Republic | 53.6 | 3.5 | 275 |
| Hungary | 55.7 | 3.2 | 259 |
| Poland | 38.6 | 6.7 | 425 |
In percent of German GDP per worker, average 1994-1999.
Cobb-Douglas production function.
In percent of pre-flow GDP.
The main policy conclusion drawn by economists is that open capital markets reduce the independence of action for monetary policy requiring more reliance on fiscal policy as the main instrument of stabilization. In stark contrast, Arvai (2005) finds that most NMS used monetary and exchange rate policies as the main instruments to counteract excessive capital inflows, whereas fiscal policy was rarely adopted. FDI was the largest component of capital inflows ($134 billion) to the NMS (excluding Cyprus and Malta) over 1995-2003, with interest-sensitive portfolio investments relatively low ($28 billion), and other investments (trade and financial credits) about $41 billion. Arvai finds that the pace of deflation was the major determinant for portfolio inflows as most of the monetary authorities decided to maintain positive real interest rates to fight inflation and encourage savings. The Czech Republic managed to achieve low inflation by 1999 and virtually eliminated the interest rate differential with the Euro zone. Hungary and Poland with slow disinflation and high public debt were the most vulnerable to surges in portfolio flows, with nominal interest rates converging to Euro zone levels only recently.
Myth 8: Real exchange rate appreciation reflects economic fundamentals and will not undermine the basic competitiveness of the economy?
The experience of the NMS suggests the real exchange rate can overshoot and pressures can last many years.
81. Real appreciation pressures in Romania appear to have eased, following the rapid real appreciation of the leu after the liberalization of the capital account in April 2005. Policymakers are now asking:
Is the process over? The capital account is largely liberalized and much of the undervaluation of the exchange rate has been eroded, or
are appreciation pressures likely to continue for a few more years resulting in potentially costly adjustment?
Among Romania’s forerunners, strong real appreciation in the Czech Republic and Poland slowed in the early 2000s, but continued in Hungary through 2004 (Figure 8). Several studies suggest that the strong real appreciation in these countries in the 1990s cannot be fully explained by increasing productivity in the tradable goods sector (the so-called Balassa-Samuelson effect). Foreign direct investment has been seen as the main culprit. If this is the case, FDI may result in future net export gains, and justify real appreciation. Bulir and Smidkova (2005), for example, show that fundamentals explain about 60 percent of the real appreciation in the Czech Republic, Poland and Hungary. They attribute the rest to overly optimistic expectations about the speed of real convergence, the temporary impact of privatization flows and the psychological effect of EU enlargement.
Composition of Capital Flows, 1994–2004 US dollars millions
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Source: World Economic Outlook, and staffs’ calculations.Composition of Capital Flows, 1994–2004 US dollars millions
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Source: World Economic Outlook, and staffs’ calculations.Composition of Capital Flows, 1994–2004 US dollars millions
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Source: World Economic Outlook, and staffs’ calculations.
Real Effective Exchange Rate, 1994-2004 CPI-based index 2000=100
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Real Effective Exchange Rate, 1994-2004 CPI-based index 2000=100
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Real Effective Exchange Rate, 1994-2004 CPI-based index 2000=100
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
82. Strong capital inflows in these three countries contributed to a move to more flexible exchange rate arrangements. After 1999, the Czech Republic received increasing amounts of FDI, which it largely sterilized. Poland and Hungary attracted large amounts of interest sensitive inflows in addition to sizable FDI. Both countries preferred to allow substantial appreciation rather than heavy intervention. At the same time, interest rate policy in these countries became more active. In the Czech Republic low inflation was achieved relatively quickly, whereas in Hungary and Poland the disinflation process was slower leading to persistent portfolio inflows. In Poland, low single digit inflation was achieved in 2002 and in Hungary in 2005, with large interest rate sensitive inflows accompanying tight monetary policies. The pattern of real appreciation largely followed these policy changes (Figure 8).
83. For Romania, the real appreciation pressures from capital inflows started late compared with its forerunners. The Balassa-Samuelson effect is thought to have contributed to earlier real appreciation and is expected to continue as the economy is still undergoing structural reforms. With the concentration of capital inflows on FDI and trade and financial credits, Romania looks more like Poland in 1999, Hungary in 2000 or the Czech Republic in the mid-1990s before disinflation was achieved. On the other hand, the influence of “non-fundamentals” in Romania such as privatization proceeds, the pull of EU accession and optimistic assumptions about real convergence are likely to be short-lived given the late start and imminent EU accession. In the NMS, there was a drop-off in FDI just before accession as by that time investors had already established themselves in the markets. Future FDI is now expected to depend more on the overall perception of investors of the strength of the economies and the stability of macroeconomic policies. In Romania, the opening up of the government debt market may give some additional boost to capital inflows but the size of the market is small, and the January 2006 liberalization has been effectively delayed. The portfolio market is also underdeveloped and will only assume greater importance for capital inflows in the medium-term. With an expected shift in the composition of capital away from FDI to portfolio flows, the importance of interest rate sensitive flows will only increase, suggesting that the speed of disinflation will be key for Romania to avoid the experience of Poland and Hungary.
Myth 9: EU accession will bring about rapid structural changes in the economy and productivity improvements.
The experience of the NMS has been positive but growth has been unbalanced and economic structures slow to change.
84. What can Romania reasonably expect from the experience of its forerunners in terms of convergence with the economic structures of the EU-15? For the countries of central and eastern Europe membership of the European Union has been seen as the key to higher productivity and structural change. The existing literature on the growth and convergence prospects is largely optimistic about the advantages of economic integration with the EU (Schadler and others, 2005). During the first ten years after reforms, the CEEC-814 experienced a boom in economic activity with productivity and real wages growing by 8 percent annually (Berns (2004)). Most models, however, suggest that convergence is a long-term process. Recent European Commission estimates indicate that, assuming an average growth rate in the NMS of 1.5 percent above the EU average, it will take 25 years for these countries to reach the current level of income in the EU. In addition, growth in real wages has been imbalanced both regionally and in terms of labor skills. In Hungary, the level of GDP per head in the most prosperous regions is about 2 ½ times that in the least prosperous regions. FDI has tended to increase wages for high skill younger workers. Medium-skilled manufacturing workers have seen much less improvement, and the benefits for low skill workers have been in terms of employment not real wages (Geishecker, 2004).
85. Low wages in Romania correspond broadly to lower labor productivity as a result of lagging behind the other CEEC-8 in the 1990s in terms of restructuring, stabilization policies, and the development of physical infrastructure. One reason is differences in the sectoral composition of output. In Romania, the share of agriculture, which has low productivity, was 12 percent of GDP in 2003, compared to about 4 percent in the NMS. Angeloni and others (2005) show that EU integration cannot be expected to result in rapid structural transformation of the central and eastern European economies unless accompanied by more vigorous and targeted structural reforms (Table 4). The share of employment by sector in the NMS hardly changed between 1995 and 2003, and remains substantially different from that in the more advanced economies (EU-15 and U.S). The authors show that the lack of structural convergence is a key determinant of slow real income convergence.
Structural Change? Output Composition of Employment, 1995-2003
Structural Change? Output Composition of Employment, 1995-2003
| New Member States | EU-15 | USA | ||
|---|---|---|---|---|
| 1995 | 2003 | 2003 | 2003 | |
| Agriculture | 17.4 | 16.7 | 4.6 | 1.6 |
| Construction | 6.6 | 6.1 | 7.1 | 5.6 |
| Manufacturing | 22.9 | 20.7 | 18.1 | 14.6 |
| Energy | 2.8 | 2.8 | 0.1 | 0.7 |
| Services | 50.3 | 53.7 | 70.1 | 77.5 |
Structural Change? Output Composition of Employment, 1995-2003
| New Member States | EU-15 | USA | ||
|---|---|---|---|---|
| 1995 | 2003 | 2003 | 2003 | |
| Agriculture | 17.4 | 16.7 | 4.6 | 1.6 |
| Construction | 6.6 | 6.1 | 7.1 | 5.6 |
| Manufacturing | 22.9 | 20.7 | 18.1 | 14.6 |
| Energy | 2.8 | 2.8 | 0.1 | 0.7 |
| Services | 50.3 | 53.7 | 70.1 | 77.5 |
86. The experience of the NMS suggests that the impact of strong FDI on productivity, while positive, may not bring as rapid a transformation as hoped. Much of the benefit of accession has already been anticipated by investors and international companies have already made substantial inroads into the domestic markets. Geishecker (2004) shows that foreign-owned firms were quick to establish themselves in central and eastern Europe. Indeed, by 2002 foreign penetration of industry in Romania, at 33 percent, was the same as that for the Czech Republic and Poland a year earlier, although significantly below the 45 percent penetration in Hungary (Table 5). For non-manufacturing, Geishecker’s estimates indicate a dominating role for “horizontal” FDI in the region, with future growth depending largely on the growth of the domestic market rather than geared for export. By the time of EU accession all economic sectors in the NMS had been largely opened up to foreign investment, with most horizontal FDI going into services, dominated by banking, retail, telecommunications, and real estate.
Share of Foreign Firms in Employment by Industry in 2001
(percent)
Share of Foreign Firms in Employment by Industry in 2001
(percent)
| Czech Rep. | Hungary | Poland | Romania (2002) | |
|---|---|---|---|---|
| Food and beverage | 22 | 38 | 30 | 27 |
| Tobacco | 97 | 95 | 79 | 25 |
| Textiles | 24 | 33 | 20 | 40 |
| Clothing | 21 | 36 | 33 | 38 |
| Tanning | 17 | 52 | 26 | 45 |
| Wood | 25 | 22 | 34 | 28 |
| Paper | 45 | 44 | 53 | 35 |
| Publishing | 33 | 20 | 45 | 20 |
| Coke and petroleum | 31 | 100 | 41 | 56 |
| Chemicals | 27 | 58 | 29 | 20 |
| Rubber and plastic | 47 | 49 | 47 | 59 |
| Non metallic minerals | 37 | 37 | 40 | 27 |
| Basic metals | 28 | 42 | 10 | 54 |
| Fabricated metals | 30 | 25 | 20 | 20 |
| Machinery n.e.c. | 21 | 41 | 18 | 15 |
| Office machinery | 86 | 33 | 25 | 31 |
| Electrical machinery | 58 | 76 | 54 | 53 |
| Radio and TV sets | 66 | 83 | 58 | 54 |
| Medical equipment | 38 | 41 | 26 | 18 |
| Motor vehicles | 70 | 69 | 68 | 36 |
| Transport equipment | 8 | 22 | 14 | 31 |
| Furniture | 23 | 26 | 47 | 17 |
| Recycling | 18 | 37 | 26 | 24 |
| Manufacturing | 34 | 45 | 33 | 33 |
Share of Foreign Firms in Employment by Industry in 2001
(percent)
| Czech Rep. | Hungary | Poland | Romania (2002) | |
|---|---|---|---|---|
| Food and beverage | 22 | 38 | 30 | 27 |
| Tobacco | 97 | 95 | 79 | 25 |
| Textiles | 24 | 33 | 20 | 40 |
| Clothing | 21 | 36 | 33 | 38 |
| Tanning | 17 | 52 | 26 | 45 |
| Wood | 25 | 22 | 34 | 28 |
| Paper | 45 | 44 | 53 | 35 |
| Publishing | 33 | 20 | 45 | 20 |
| Coke and petroleum | 31 | 100 | 41 | 56 |
| Chemicals | 27 | 58 | 29 | 20 |
| Rubber and plastic | 47 | 49 | 47 | 59 |
| Non metallic minerals | 37 | 37 | 40 | 27 |
| Basic metals | 28 | 42 | 10 | 54 |
| Fabricated metals | 30 | 25 | 20 | 20 |
| Machinery n.e.c. | 21 | 41 | 18 | 15 |
| Office machinery | 86 | 33 | 25 | 31 |
| Electrical machinery | 58 | 76 | 54 | 53 |
| Radio and TV sets | 66 | 83 | 58 | 54 |
| Medical equipment | 38 | 41 | 26 | 18 |
| Motor vehicles | 70 | 69 | 68 | 36 |
| Transport equipment | 8 | 22 | 14 | 31 |
| Furniture | 23 | 26 | 47 | 17 |
| Recycling | 18 | 37 | 26 | 24 |
| Manufacturing | 34 | 45 | 33 | 33 |
87. Romania’s labor cost advantages will remain for some time, but indications from earlier accessions suggest that FDI will not result in significant wage catch-up in the low-skilled sectors. Most studies confirm that convergence is a long-term phenomenon, and much will depend on how efficiently Romania uses rapid growth to spur reforms and restructure the economy. Interestingly, Halpern and Wyplosz (1997) show that in both developed and emerging countries a 10 percent decline in the size of agriculture relative to industry can increase euro wages by 1-2 percent. In Romania, the efficient use of EC structural and cohesion funds by increasing investment in physical infrastructure and pushing reforms in agriculture will therefore be an important factor for raising living standards.
Myth 10: Large budget deficits are part of transition and are needed to fund investment?
There is little relation been deficits and investment in the NMS. The lax fiscal policies in the NMS compared to other emerging markets may reflect a particular view of the trade off between real and nominal convergence. The main problem in Romania is low revenues.
88. The fiscal accounts of the NMS deteriorated markedly in the period to EU entry. There were no macroeconomic conditions connected with accession to the EU, with an implicit notional trade-off between “real” and “nominal” convergence. In particular, there was a common view that budget deficits could be “tolerated” as they are instruments for financing investment and growth during transition. As such, there was something of a “coincidence between populist pressures in these countries for higher deficits and EU institutions…which favored a slow process of entry to the Eurozone” (Coricelli, 2005). Romania faces particular challenges as it enters the race for real convergence, given its low revenue base compared with the NMS (Figure 9). Pressures to preserve recent tax cuts combined with spending demands related to EU accession have made it even harder to use fiscal policy as a tool for macroeconomic management.
Revenue as a Percent of GDP, 2005
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Revenue as a Percent of GDP, 2005
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Revenue as a Percent of GDP, 2005
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
89. A comparison between the low deficit transition countries such as the Baltics and Slovenia and other larger high deficit countries, such as Hungary and the Czech Republic, suggest that high deficits cannot be attributed to EU convergence as they have all been subject to the same transition process. There is no clear correlation between the size of budget deficits and public investments, contrary to what is often heard as justification for high deficits in NMS (Figure 10). The difference in size of the countries suggests political economy factors may be important, as well as the stronger constraints facing small open economies.
Share of investment and budget deficits, 2004
(Percent)
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Share of investment and budget deficits, 2004
(Percent)
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
Share of investment and budget deficits, 2004
(Percent)
Citation: IMF Staff Country Reports 2006, 169; 10.5089/9781451832860.002.A003
90. Perhaps one explanation is that low debt-to-GDP ratios in the NMS compared with the EU-15, have been seen as justifying higher deficits. However, NMS debt should be seen as emerging market debt and subject to the same volatilities and risks. Debt ratios in Latin America are of similar magnitudes, for example. NMS still have underdeveloped financial markets and debt to M2 ratios are closer to those of the EU-15, and in the case of Poland and Hungary are higher. NMS also show higher volatility of revenues to GDP during the transition process, while expenditures have shown rigidity, suggesting a greater vulnerability to shocks in general. The debt ratio for Romania remains low, but much will depend on the future direction of policy.
So “Myths” or “Not?” Pressures reflect transition, but policies have too as well.
91. The prospect of EU accession has undoubtedly spurred market reforms in the acceding states of central and eastern Europe. Romania is now seeing some of the benefits with strong inflows of investment and rapid growth. However, the experience of the early accession states suggests that real convergence is a slow process and should be carefully managed. Even with strong growth it will take Romania many decades to reach EU income levels. Set against such prospects is the current optimism misplaced? Are policy makers wrong to believe that macroeconomic imbalances resulting from transition will correct themselves over time? We have shown that there is a mix of “myth and reality” in many of the notions concerning the transition. Certainly, many of the pressures are a direct result of the transition process. However, these pressures will remain for several years and sustained economic growth will depend on how successfully governments are able to manage the transition. Past experience suggests that prudent macroeconomic policies are essential to ensure smooth real and nominal convergence and to minimize the inevitable risks in what will inevitably be a “long march” to EU income levels.
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