Economic Developments in Central and Eastern Europe in 2001 and Outlook for 2002

With the exceptions of Macedonia and Poland, 2001 was not a bad year for Central and Eastern Europe, especially in light of all the economic turmoil throughout the rest of the world. Ironically, after a tumultuous decade in the 1990s, in 2001 the transition economies have been relatively immune to economic recession. In Central Europe in 2001, economic growth accelerated in the Czech Republic and Slovakia to 3 percent or more. PlanEcon projects Hungary will post a final figure of 4 percent and Slovenia will register 3.4 percent growth for 2001, commendable performances in both cases, although lower rates than in 2000. In addition, these two countries enjoyed better balance in their economies. Inflation has fallen. Hungary's current account deficit has narrowed sharply; Slovenia's deficit has turned to surplus.

The odd man out in Central Europe in 2001 was Poland. Growth slowed sharply, from 4.0 percent in 2000, to just above 1 percent in 2001. Much of the slowdown has been self-inflicted. Overly tight monetary policies coupled with a sharp deterioration in the fiscal balance has resulted in very high real interest rates, which have dragged the economy down. Exports have been one of the key factors keeping Poland's economy out of recession. Unfortunately, despite a cumulative 750 basis-point cut in interest rates during 2001, interest rates remain very high in real terms, in part because inflation has fallen sharply as well. Interest rate cuts appear to work through the Polish economy relatively slowly. Corporations often borrow abroad in foreign currencies and at euro interest rates. For these companies, exchange rate developments are more important than developments in zloty interest rates. Many Polish households still have very limited access to bank credit. Consequently, rate cuts have yet to trigger a rebound in consumer spending.

Falling inflation has been a feature throughout Central Europe in 2001. Inflation has fallen sharply everywhere except in the Czech Republic, where it had already been low - 4.0 percent in 2000. Poland has experienced the most precipitous drop with a December-to- December inflation fall to 3.6 percent in 2001, from 8.5 percent in 2000. Producer price inflation has fallen even more dramatically, nearing Eurozone rates.

Looking forward, PlanEcon projects another year of relatively modest growth in Central Europe. All five countries are forecast to enjoy a slight acceleration of growth, with an emphasis on slight. Growth in Poland is projected to remain less than 2 percent in 2002. The other countries are projected to enjoy growth of 3 to 4 percent, very respectable performance in the current global economic environment. Performance on inflation is projected to be more mixed with declines in average annual rates in Hungary and Poland, but some acceleration in the Czech Republic and Slovakia. Current account balances are projected to deteriorate in every Central European state.

As PlanEcon had forecast, most of the Balkan states had a good year in 2001. Of the larger economies, Romania had a great year with projected growth in GDP of 5.2 percent, the first year of strong economic growth since 1996. Moreover, Romania generated this rate of growth in the context of falling inflation; in 1996, inflation was accelerating rapidly. The last few years of privatization and cleaning up some of the mess in the operations of Romania's government have paid off. Although still difficult, both foreign and domestic businesses now find it possible to create value in the Romanian economy. The only black spot for Romania has been its widening current account deficit. Poor government policies coupled with very rapid growth in aggregate demand (a projected 8.8 percent for 2001) have precipitated a flood of imports. However, toward the end of 2001, growth in import demand appeared to be slowing.

Like Romania, Albania, Bosnia, Bulgaria, and Croatia all enjoyed solid growth in 2001, although at the expense of widening current account deficits. In all cases, exports continued to expand even as growth in demand in key markets in the EU slowed. Because of investment by foreign firms and the development of ties with West European distributors, these Balkan countries are becoming much more integrated into the West European economy. Because of these commercial connections and because wage rates are so low, these countries have been able to boost exports even in the face of stagnant or falling aggregate demand in Germany and other key markets.

The Balkan states are also benefitting from falling barriers to trade in Central and Eastern Europe. Many countries are signing free trade agreements with their neighbors. Bulgaria and Macedonia have signed a free trade agreement as have Bosnia and Croatia. Bulgaria and Romania have already joined the Central European Free Trade Area and Croatia is negotiating accession to this group. The EU has been generous with market access, negotiating Stabilization and Association Agreements with the Balkan states that do not have Europe Agreements. These agreements have facilitated recent increases in exports.

In a number of Balkan countries, inflation rates have been lower than those in Central Europe. In others, such as Romania, they have been considerably higher. The low rates of inflation in Albania and Bosnia stem from exchange rate stability and the overwhelming role of food in the consumer price basket. All the Balkan states are dual currency economies: households and businesses hold cash balances in dollars and euro. Consequently, prices are heavily influenced by exchange rate movements. When exchange rates are stable, inflation falls. Food prices also play a large role in determining inflation rates in the Balkans. In years in which harvests are good, supply factors have kept consumer price inflation low. Finally, price pressures from nominal wage growth have been less strong in the Balkans than they have been in Central Europe. Because of very low levels of productivity, there has been more scope for increases in productivity in the service sector than in Central Europe, mitigating the effects of increases in nominal wages on consumer price inflation.

The odd man out in the Balkans in 2001 was Macedonia. Macedonia once again illustrates the importance of domestic security for economic growth. After 4.3 percent growth in 1999 and 2000, Macedonia's economy entered free fall in the first half of 2001, as fighting broke out between ethnic Albanians and Macedonians in the northwestern part of the country. The economy has now stabilized, but only after NATO restored peace and the EU and the IMF stepped in with financial assistance. If fighting breaks out once more, the GDP will fall again.

Going forward, PlanEcon projects continued solid growth in the Balkans in 2002 and beyond. In fact, we project more rapid growth in this region than in Central Europe over the next few years. The Macedonian and Yugoslav economies are projected to rebound as they recover from the economic residue of the armed conflicts of the past few years. Bulgaria is projected to enjoy growth in the 4 to 5 percent range while Romania is forecast to continue to excel. However, output growth is projected to slow in Albania and Bosnia where growth rates have been in the high single digits.

EU Enlargement Becoming a Reality

One of the most important economic developments for the Central European states in 2001 has been the progress made toward accession to the EU. The prospect of membership for five Central European states as well as the three Baltic countries, Cyprus, and Malta by January 1, 2005, is now very real.

This progress was reflected in the annual strategy report and 13 individual reports for each of the candidate countries issued by the European Commission on November 13, 2001. Aside from Bulgaria, Romania, and Turkey, the reports, although often critical, indicate that so much progress has been made toward meeting the criteria for enlargement to make membership for these 10 countries in 2004 almost an inevitability. At the EU Summit in Laecken, Belgium in December 2001, the EU notified the applicant countries that negotiations on making the legislation of the applicant countries consistent with the EU's acquis communaitaire should be completed in 2002. The Commission will also be pushing the candidates to improve the implementation in 2002 of the new laws and regulations they have been passing. To speed this process along, the Commission has promised an additional 250 million euro in 2002 in addition to the 750 million euro previously budgeted, to assist the countries to restructure their bureaucracies and more effectively implement the acquis.

The reports for the ten leading candidate countries contained no nasty surprises. The strategy paper congratulated all the candidate countries on their progress to date. However, it definitely divided the candidate countries between the sheep and the goats: the ten on track for the first round of accession and the three other countries (Bulgaria, Romania, and Turkey) that are not yet ready.

The European Commission strategy report states that negotiations with successful applicants should be completed by the end of 2002 and that successful applicants would be able to become EU members in 2004, an objective that had previously been set by both the European Parliament and the European Council. PlanEcon is less optimistic than the Commission. We believe that negotiations with a few of the successful candidate countries will run over into the first quarter of 2003. The chapter on agriculture is particularly knotty as the EU itself has not yet decided upon a reform of the Common Agricultural Policy (CAP) to make inclusion of the accession countries financially feasible. In fact, the Commission admits that the agricultural chapter cannot be completed until the EU makes decisions on the reform of CAP. At one time, the Commission considered excluding new members from participating in CAP for a period. It now appears that the applicant states will participate in CAP upon accession. Because payments must fit into the overall EU budget, however, payments under CAP will have to be severely limited. A recent proposal by the Commission would limit support to accession countries to 25 percent of what they would receive under current EU rules.

In the Strategy Report, the Commission emphasizes that the European Council meeting held in Berlin provided a sufficient legal and financial basis for the EU to admit up to 10 new members under current EU voting and operating procedures. The Commission argues that a new financial agreement among members will not be necessary before 2006, when decisions on the next medium-term budget plan are scheduled to be made. This statement constrains enlargement negotiations on agriculture, regional policy, and financial and budgetary provisions because it states that no additional funds will become available to the EU budget until after 2006. Thus, spending on the accession countries must fit into the budgetary constraints of the current financial plan. However, funds that had been designated for the accession countries in 2002 and 2003 under the assumption that some of them would have been members by that time, will be available in 2004 and 2005, easing some budgetary concerns.

Under the Berlin agreement, the EU budget is tightly constrained concerning funds available for income supports. Negotiations over agriculture will center on the level of supports and the numbers of farmers eligible in each country. In the case of Poland, for example, the EU may seek to limit the number of farmers eligible for income supports by stipulating a relatively high minimum size for eligible farms or by prohibiting income supports for individuals who work off the farm. Because many Polish farmers cannot make ends meet without off-farm income, such an approach would substantially restrict the number of eligible recipients. In addition, the EU will probably attempt to keep the level of income supports to East European farmers as low as possible.

In the midst of enlargement negotiations, the EU has also scheduled a "constitutional convention" or Intergovernmental Conference (IGC) to begin this year and finish in 2004. The IGC will address changes in the political structure of the community. Key issues concern the principle that each state is entitled to nominate one commissioner, that each state receives a rotating six-month term as the president of the European Union, and that on a number of issues, each state may exercise a veto. Because a number of applicant states are very small in terms of population and GDP, the question of voting weights is becoming ever more important. Estonia, Latvia, and Slovenia all have populations of 2.4 million or less. Cyprus only has 800,000 inhabitants and Malta, 400,000. It appears that the Commission is skeptical that a comprehensive reform of the EU can be completed by 2004. In the Strategy Report, the Commission states that " discussions within the European Union on the reform of policies or institutions should be clearly separated (from enlargement) and not hinder or slow down the accession negotiations." A delay in concluding the IGC would probably be healthy for the EU, as the accession countries would then become full participants.

In addition to the ICG, PlanEcon sees a number of pitfalls for the ratification process in both the EU and the candidate countries. The Czech government has promised to hold a referendum on membership. Support for membership has been waning, although supporters are still in the majority. A nasty tiff with Austria over the opening of the Temelin nuclear power plant could precipitate a backlash among Czech voters. Estonians have also become more lukewarm about the EU and a sizeable share of Polish voters - over 25 percent - voted for anti- EU parties in recent elections. Changes in governments, elections in the Czech Republic, Hungary, and Slovakia, and disagreements over remaining issues make completion of negotiations by December 2002 a very ambitious target. Despite these concerns, for economic, psychological and security reasons, it is highly unlikely that any of the candidate countries would decline an invitation to join the most important club in Europe.

The greater dangers for delay lie on the EU side. Although German concerns about hordes of East European job seekers flocking to the country have been somewhat allayed by the negotiation of a seven year postponement of the free movement of labor, Austrians are still upset about nuclear power. A public opinion poll conducted on November 17, 2001 indicated that 47 percent of Austrians believe that their government should veto the Czech Republic's entry into the EU if Prague refuses to close down the Temelin nuclear power plant.

Opinion polls indicate that outside of Austria and Germany, enlargement is not yet a major domestic political issue; most citizens of current EU member states support it. The general reading of the results of the Irish referendum on the Nice Treaty is that many of the people who voted "no" were protesting against the actions of the Commission and the European Central Bank (ECB). The ECB's criticism of Irish tax cuts went down badly in Ireland. Opinion polls also indicate a rising level of dissatisfaction with regulations issued in Brussels that are felt to be too rigid or nonsensical. This rising level of dissatisfaction could spill over into "no" votes in countries that choose to submit the enlargement question to a referendum. Extended parliamentary debates that include some EU bashing are almost inevitable. Extended parliamentary debates on ratification are almost certain to push formal accession into the second half of 2004 or, as we believe, to January 1, 2005. In this event, the applicant countries will still participate in the 2004 elections for the European Parliament; their delegates will just not take their seats until ratification is completed. In short, in our forecasts PlanEcon assumes that ratification will slip into the last half of 2004, resulting in entry by January 1, 2005.

In the Strategy Report, the Commission is very blunt about the use of the euro. It states, " candidate countries will have to conform to the convergence criteria for participation in the euro." Membership in Economic and Monetary Union will be decided at a later date after accession. Candidate countries are forbidden to adopt the euro unilaterally before admission to EMU. We find this decision unfortunate. In our view, the candidate countries would benefit from the immediate adoption of the euro as it would eliminate exchange rate risk. Membership in the ECB could come at a later date. The Commission also has placed strictures on exchange rate regimes after accession. Accession countries are forbidden to use free floats, pegs to currencies other than the euro, or crawling pegs. Of the eight leading East European countries, only Estonia, Hungary, and, as of very recently, Lithuania currently meet these standards. The Czech Republic, Poland, Slovakia, and Slovenia ostensibly use floating rates, although only Poland allows its currency to fluctuate much. These countries will need to change their exchange rate regimes in the next two years. Despite its rigidity in terms of use of the euro, the report focuses more on fiscal than monetary policy. The report takes to task most of the East European countries for overly large budget deficits and strongly encourages them to rein in these deficits in the near future.

The EU's rigid adherence to the Maastricht criteria for admission to Economic and Monetary Union for Central Europe is unfortunate. According to these criteria, after the Central European states are admitted to the EU, they will still have to wait at least three years before adopting the euro, and only then after meeting targets for government debt as a share of GDP (it must be under 60 percent), inflation, and interest rates, among others. We see no problem for the Central European states to meet the criteria on government debt levels and interest rate convergence. Now that prospects for membership in the European Union are nearing reality, inflows of foreign portfolio investment are rapidly narrowing the gap between Central European and Eurozone interest rates. However, if Central Europe is to grow, consumer price inflation will have to exceed West European levels in the coming years. In the context of stable exchange rates, producer price inflation has quickly fallen to Eurozone levels, but consumer price inflation has not. Rapid growth in productivity in manufacturing, especially in export sectors, has driven sizeable increases in nominal wages in those economies that are enjoying growth. These increases have spilled over into wage increases across the economy, driving price pressures in household services, government, and other sectors serving the domestic economy. For example, average wages in Hungary rose by over 20 percent in euro terms in 2001. These increases in nominal wages are the means by which the transition economies will narrow the euro income gap with Western Europe. But these rapid increases in wages also push up domestic inflation, making it virtually impossible for Central European states to reduce inflation to West European levels during times of economic growth. In addition, the Central European states will have to continue to increase administratively controlled prices for electricity, natural gas, and rents towards cost- recovery levels in coming years. These increases will also boost inflation.

The Strategy Report also addresses the concerns of the three countries that will not be included in the first round of enlargement. The Commission promises to lend its full support to assisting countries that have applied, but will not yet be eligible for membership, to make the changes necessary to eventually become members. The Commission also states that it will not modify its membership criteria to enable countries that do not meet these criteria to join. It promises to provide clear guidelines to eventual membership for countries that will not be accepted for membership at this time. The report also emphasizes that Turkey faces real prospects of eventually becoming a member of the EU.

From an economic view, there is no reason why enlargement should not be successful. But current EU members will be in for some surprises. Despite the political and bureaucratic commitment to enlargement, PlanEcon came away with the impression that the EU is approaching accession much as it has approached the transition: assuming that the major adjustments will take place in the accession countries rather than the EU itself. We do not believe that the current member states have yet to fathom the enormity of the changes that will take place in the EU after enlargement. The number of very small countries will rise from one (Luxembourg) to six. The number of very small economies will rise from one to ten. Differences in incomes will be enormous. The political task of making decisions in a group of 25 much more disparate countries will be very different and much more difficult than with a group of 15, more similar countries. The sheer change in numbers will result in a decline in the decision-making power of states like France, which has had great influence on EU policies in the past. In this larger group of countries, politics will become much more fluid; coalitions of countries will constantly form and break apart, and the EU will become a very different polity than it has been in the past decade.

Mr. Crane spoke at an EES noon discussion on February 6, 2002. The above is a summary of his presentation.Meeting Report #249.