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Central Europe: From Transition to EU Membership
Robert A. Feldman and C. Maxwell Watson
The Central European countries have made considerable progress with the transition to a market economy and now face the challenge of developing macroeconomic policy frameworks on the road to EU accession.
The countries of Central Europe—the Czech Republic, Hungary, Poland, Slovakia, and Slovenia—are among the more advanced transition economies. They are a diverse group, with per capita incomes ranging from $3,500 in Slovakia to $9,900 in Slovenia, different industrial structures, and varying degrees of openness to trade. As they prepare to join the European Union (EU), they face a dilemma in developing viable medium-term macroeconomic policy frameworks. A key role of their monetary and fiscal frameworks will be to ensure low inflation and manageable fiscal deficits and, generally, to anchor expectations and foster stability. But these frameworks will need to cope with the challenges and uncertainties of real convergence with the EU countries, high and possibly volatile capital inflows, and financial sector change, all of which complicate policy formulation.
Building on past success
The transformation of the Central European economies over the past decade has been radical. The private sector's share of GDP has increased to 60 percent or more. Two-thirds of these countries' exports are sold in EU markets, and the European Union provides two-thirds of their foreign direct investment inflows. Inflation is in, or close to, single digits. External debt is low or declining, and the international reserve cover of central banks is generally strong. A key in the most successful countries—Hungary and Poland—has been the meshing of macroeconomic and structural adjustment: imposing hard budget constraints on firms, freeing prices, opening trade, and reforming the financial sector.
Progress on structural reforms has been uneven, however. For example, Hungary and Poland have made striking headway in dealing with quasi-fiscal liabilities. This is less the case for the Czech and Slovak Republics. Industrial restructuring is largely complete in Hungary, but the other Central European countries lag behind. All of the Central European countries still have much to do in reforming the public sector, improving infrastructure, and protecting the environment.
Challenges en route
Structural reforms in the Central European countries will therefore need to continue, although to different degrees. Because of their proximity to EU markets and the relatively high real rates of return on investment, further restructuring will likely take place in circumstances in which these economies are benefiting from sizable inward investment, all the more so as approaching EU accession engenders confidence in them—not to mention the expected benefits of accession itself. However, capital inflows can be expected to complicate the conduct of monetary and fiscal policies, either by putting unwanted upward pressure on inflation and exchange rates or by causing excessive external current account deficits—all of which would require a policy response. More generally, high productivity growth in the traded goods sectors, in addition to general structural changes, may result in pressures for real exchange rates to appreciate. This would imply that these economies cannot simultaneously achieve both convergence to very low inflation rates and nominal exchange rate stability. Depending on the scope of structural reforms and infrastructure improvements, policy in some countries may also come up against early overheating in their more advanced regions.
Changes in the financial sector will also affect policy frameworks. The financial sector plays a special macroeconomic role for four reasons: a financial crisis can cause major economic disruptions and sizable fiscal costs; banking resilience is crucial for a flexible interest rate policy and predictable and effective monetary transmission; efficient intermediation is essential for enhancing growth; and good risk management, by limiting unhedged borrowing and discouraging flows driven by moral hazard, helps to minimize potential problems from inflowing, potentially reversible capital.
Monetary and exchange rate policies
At present, the exchange rate and monetary policy regimes of the Central European countries differ. These regimes now include inflation targeting in the Czech Republic and Poland, with Slovakia moving in that direction; monetary targeting in Slovenia, with short-term capital controls intended to reduce exchange rate volatility; and a crawling peg and narrow-band arrangement in Hungary, supported by controls on short-term capital. Indeed, even when these countries adopt the wide bands of the exchange rate mechanism of the European Monetary System (±15 percent around a fixed central rate under ERM2), they may opt for differing degrees of flexibility within the band.
The merits of different regime options are still being debated in academic and official circles, but three issues are always relevant in formulating monetary policy. First, it is important to ensure that the regime will be consistent with inflation objectives. This involves deciding whether real currency appreciation is to be absorbed by allowing the currency to appreciate in nominal terms or by allowing prices to rise. Second, the changing structure of the financial sector and shifts in money demand make the choice and use of nominal anchors for monetary policy more difficult, in part because the transmission mechanism may be unpredictable, complicating inflation- and monetary-targeting regimes. Third, and more fundamentally, in the presence of potentially strong and variable capital inflows, monetary policy cannot, by itself, foster the degree of real exchange rate stability that would be desirable to ensure a fairly smooth path for output and expectations. Other measures are key to minimizing the risks of a bumpy ride for the real economy: first, ensuring the health of the financial sector—minimizing distortions, including implicit guarantees, that could encourage unwanted capital inflows, and allowing monetary policy to operate flexibly; and, second, developing sound management of fiscal policy to help the country cope with variable capital inflows. Absent these measures, neither fixed nor floating exchange rate regimes will deliver the best possible economic performance.
Several factors complicate the design of fiscal policy. First, in some countries, significant restructuring costs still have to be absorbed by public finances, and the cost of reforms in public services, such as health care, could be substantial. Countries will also have expenditures associated with the adoption of the acquis communautaire—the European Union's laws and institutions. Second, the fiscal impact of public sector reform is hard to quantify, making it difficult to set appropriate spending ceilings; and fiscal decentralization—despite its possible advantages—also complicates expenditure control. Third, although taxes on labor are typically too heavy, there is uncertainty about how fast the total tax burden on the economy can realistically be cut. Fourth, if private saving does not increase in parallel with private investment, public saving will have to increase to relieve pressure on external current accounts. There is a general question of how far fiscal policy may be called on to limit the size of external current account deficits, particularly if monetary policy is directed to lowering inflation.
The following six steps can help in designing a sound fiscal framework (see box for an application to Hungary):
Even in a country as advanced as Hungary, the authorities' goals for fiscal policy—achieving the fiscal deficit target, reducing the tax burden, ensuring adequate capital expenditure, and completing needed reforms—could well come into conflict with each other. Although the other Central European countries have public debt ratios well below Hungary's, they also have large current account deficits or quasi-fiscal liabilities that will constrain fiscal policy over the medium term.
The limitation of a purely annual approach to fiscal policy is that it provides policymakers with less opportunity to manage resources strategically, and there is a risk that capital spending will be squeezed from year to year. The step-by-step approach to fiscal analysis outlined above, however, is flexible. It could be applied differently, depending, in part, on how advanced a country's structural transformation is. In countries where uncertainty is very high, this approach represents a tool for identifying medium-term tensions, even though expenditure budgeting will almost certainly focus mainly on the year ahead. When fiscal costs are analytically more tractable, a framework of this kind can be used to develop medium-term expenditure projections on a rolling basis, while allowing policymakers to try to limit base drift. As the Central European economies advance, they may be able to adopt full-fledged medium-term budgeting, as practiced in a number of advanced economies, including Finland, the Netherlands, and the United Kingdom.
Although the policy challenges facing the Central European countries are daunting, they are manageable. Many EU members have faced and overcome similar challenges. Several entered the European Union—if not European Economic and Monetary Union—with large heavy industries that were state owned and unrestructured. Some experienced considerable stress in reducing their fiscal deficits to 3 percent of GDP and managing their exchange rates within a reasonable band during times of strong capital flows. Most EU members are still struggling with large contingent liabilities stemming from the prospective impact of population aging on health care and pension systems. Thus, many of these challenges are not transition issues, strictly speaking, so much as transformation challenges for these countries at an advanced stage on the road to EU membership.
This article is based on background work for Policy Reform in Central Europe: Roads from Transition to Convergence, a larger cross-country study by the authors and others, which is to be published in the IMF Occasional Paper series around the end of 2000.