## 4. SEE: Competitiveness Indicators, 2000-04

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---

### Introduction: accession goals and convergence trade-offs
- EU accession requires meeting economic, political, and legal criteria; economic criteria emphasize a functioning market economy and the capacity to cope with competitive pressure and market forces within the Union.
- Formal accession places more weight on transition reforms (real convergence) at early stages and on macroeconomic stability and nominal convergence (inflation, fiscal deficits) closer to membership and euro adoption.
- Real and nominal convergence trade-offs:
  - High investment and productivity growth needed for real convergence can be associated with higher inflation and current account deficits.
  - The Balassa-Samuelson effect (BSE) and administrative price adjustments can raise inflation during real convergence.
  - Capital inflows that finance investment can expand money supply and challenge inflation/competitiveness unless sterilized.
  - Disinflationary policies to meet Maastricht inflation targets can slow growth in the short run.
- The paper reviews progress with real and nominal convergence in SEE and macroeconomic challenges on the path to EU membership.

### Status of EU accession in SEE
- Heterogeneous accession stages and examples:
  - Bulgaria and Romania: close to joining the EU in 2007 or 2008 after five years of negotiations.
  - Croatia: applied for membership in 2003; negotiations started in 2005.
  - FYR Macedonia: granted applicant status in 2005.
  - Albania: negotiating an SAA since early 2003.
  - Bosnia: 2003 feasibility study indicated more progress was needed; police reform achieved in 2005.
  - Serbia and Montenegro: 2005 feasibility study positive; SAA negotiations initiated in October 2005.
- Practical implications:
  - Early-stage countries remain far from functioning market economies; movement from feasibility study to membership application may take years.
  - Macroeconomic stability benchmarks are looser early in the process (examples: Romania declared a functioning market economy despite high inflation; Bulgaria and Romania despite current account imbalances; Croatia despite fiscal deficits).

### Progress in establishing a market economy and real convergence
- Transition and structural reform indicators:
  - EBRD transition index scale 0 to 4; many SEE applicants’ 2004 index levels correspond to Bulgaria in 1997–98 or Czech Republic in 1992.
  - Private sector size and output recovery:
    - Serbia, Montenegro, and Bosnia: private sector shares around 50–55 percent of GDP in 2004.
  - Output recovery since 1989 weaker in SEE relative to other European transition countries.
- Risks to growth sustainability:
  - If structural reform remains slow, positive growth rates observed since 2000 may not be sustainable.
  - Critical reform areas: further privatization (especially large-scale), better investment frameworks, hardening budget constraints, financial sector restructuring.
- Privatization and enterprise sector:
  - Bulgaria, Romania, and Croatia: broadly finalized small- and large-scale privatization.
  - Serbia: limited large enterprise restructuring/privatization; subsidies and arrears keep loss-making entities afloat, contributing to negative value-added and dissaving.
- Investment climate and FDI:
  - Business environment barriers persist; firm establishment can take about 50 days in some SEE countries.
  - Corruption and governance problems persist, reflected in poor Corruption Perception Index scores.
  - FDI inflows modest at or below US$500 per capita for much of the region; Croatia highest at US$2,106 per capita.
  - Investment/GDP ratios:
    - Croatia: over 30 percent
    - Many countries: about 20–25 percent of GDP
    - Serbia and Montenegro: 18 percent of GDP in 2004
- Financial sector reforms and risks:
  - Foreign presence in banking increased; nearly all banking assets private or foreign in Albania, Bosnia, Bulgaria, and Croatia; Romania and Serbia around 50–60 percent private bank asset share.
  - Credit-to-GDP ratios in 2004 ranged from 10 percent in Albania to 60 percent in Croatia.
  - Rapid deposit growth and lending booms evident; NPLs generally low except in Serbia.
  - Risks: credit primarily finances imports; substantial foreign-currency lending increases exchange-rate vulnerability; supervision stretched; need to slow credit growth and strengthen prudential rules; high interest spreads indicate need for more competition.

### Nominal convergence — monetary frameworks, exchange rates, and inflation
- General observations:
  - Macroeconomic stability matters at all accession stages and gains importance near ERM2 and euro adoption.
  - Bulgaria and Romania face near-term decisions on ERM2 entry and euro adoption; other SEE countries need policy frameworks to reduce vulnerabilities and support sustainable growth.
  - Outcomes matter more than the specific frameworks; there are few accession-related restrictions on policy choice.
- Exchange rate anchors and inflation outcomes:
  - Most SEE countries (apart from Albania, Romania, and Serbia) have had currency boards or tightly managed floats/pegs.
  - Exchange rate anchors helped lower inflation to low single digits by 2004 in many countries.
  - Albania: loosely managed float; informal inflation targeting via money growth targeting; kept inflation low.
  - Romania: inflation remained close to double digits in 2004.
  - Serbia: shifted between nominal and close-to-real exchange rate targeting since 2000; regime shifts affected credibility and contributed to growing euroization.
- Monetary policy frameworks (summary):
  - Albania: Loosely managed float, Euro reference currency; Informal inflation targeting via money growth targeting; Moderate capital controls.
  - Bosnia: Currency board with Euro peg; Exchange rate anchor; Low capital controls.
  - Croatia: Tightly managed float, Euro reference currency; Exchange rate anchor; Moderate capital controls.
  - Macedonia: De facto peg to Euro; Nominal exchange rate anchor; Moderate capital controls.
  - Montenegro: Euro; Exchange rate anchor; Low capital controls.
  - Serbia: Tightly managed float; Exchange rate anchor; Moderate capital controls.
  - Bulgaria: Currency board; Exchange rate anchor; Low capital controls.
  - Romania: Managed float, reference Euro; Flexible inflation targeting; Low capital controls.
- Competitiveness and real appreciation risks:
  - Fixed or near-fixed exchange rates can cause unsustainable real appreciation unless fiscal and incomes policies are tight and structural reforms boost productivity.
  - Largest current account deficits occur in countries with least progress on structural reforms (Serbia, Montenegro, Bosnia, potentially Macedonia).
  - Structural reform progress alleviates external imbalances by boosting export supply and import substitution.
  - Remittances around 10–20 percent of GDP have been important; capital inflows, FDI, and private foreign borrowing have increased.
- Competitiveness indicators and REER developments:
  - Wage and productivity data for 2004 indicate potential competitiveness problems in Croatia and Macedonia (data subject to measurement problems).
  - EU export market shares suggest Macedonia may have lost competitiveness; most others increased share in EU market.
  - REERs show large appreciation in Bulgaria, Romania, and Albania in recent years; REERs relatively flat for the remainder of SEE.
- Lessons from recent new EU members:
  - Monetary regimes during accession varied; sustainability of exchange rate anchors depended on structural reform progress, prudent fiscal policy, and strong financial supervision.
- Policy implications for exchange rate anchors:
  - With slow structural reform, soft pegs carry increased risk of lost competitiveness and vulnerability.
  - Bosnia (currency board) and Montenegro (euro) may need tighter fiscal and incomes policies to maintain competitiveness and current account sustainability.
  - Serbia and Macedonia face risks if incomes policies are loosened or reforms fail to boost productivity despite tight fiscal policy.
  - Croatia’s exchange rate anchor and fiscal deficits could threaten competitiveness if capital inflows or tourism-related inflows lead to real appreciation (Croatia’s current account deficit declined in 2003 and 2004).
- Constraints on moving to more flexible regimes:
  - High euroization complicates shifts to more flexible policy:
    - Euroization of deposits: Serbia 70 percent and Croatia 87 percent.
  - Underdeveloped financial markets and limited interest rate transmission reduce scope for independent monetary policy and may increase exchange rate volatility.
  - Underdeveloped capital markets and maintained capital controls limit speculative attack risk for now, but this may change as markets deepen.
- Maastricht criteria (as listed):
  - Inflation – lowest 3 EU members plus 1.5 percent during one year
  - Fiscal deficit – below 3 percent of GDP
  - Public debt – below 60 percent of GDP
  - Long-term interest rates – below average of the three low inflation countries plus 2 percent
  - Exchange rates – within the EMS band (+/- 15 percent) for 2 years with stability around the central rate
- Bulgaria and Romania assessment:
  - Both meet Maastricht fiscal targets; Romania remains far from the inflation target.
  - Bulgaria’s currency board and relatively low inflation make ERM2 entry easier than for Romania, but both must be ready to handle large and volatile capital inflows or external shocks.

### Monetary policy and external sector risks
- August 2005 regime shift:
  - Shift in August 2005 to an inflation targeting framework and further opening of the capital account led to important speculative capital inflows that complicated monetary management and forced the central bank to intervene in the foreign exchange market to avoid excessive real appreciation and competitiveness problems.
- Policy responses needed:
  - Further flexibility from fiscal policy.
  - Continued strengthening of the financial sector.
  - Prudence with monetary management.
- Disinflation and the Balassa-Samuelson effect:
  - Estimated Balassa-Samuelson effect have ranged around 0.2–2 percent per annum on average in the recent EU members.
  - Together with potential adjustments to administrative prices, inflation may remain well above that required by the Maastricht criteria for some time.
  - The BS effect is an equilibrium phenomenon and should not be suppressed by tighter demand management policies if properly identified.
- Close monitoring and analysis of REER movements is important.
- Entry into ERM2 may not be desirable until basic transition reforms are more advanced.

### Fiscal policy challenges and priorities
- Fiscal roles:
  - Support nominal and real convergence.
  - With exchange rate anchors, be flexible enough to handle external and internal shocks to ensure external balance and low inflation.
  - Support real convergence and sustainable growth.
- Country-specific and aggregate fiscal observations:
  - Most SEE countries are still far from needing to meet the Maastricht criteria; apart from perhaps Romania and Bulgaria, near-term Maastricht compliance is not a primary concern.
  - Romania: raise more revenues to provide room for further fiscal consolidation and EU-related expenditures; current revenue-to-GDP ratio is 29 percent of GDP.
  - Some SEE countries have relatively large deficits of around 2–5 percent of GDP (Albania, Croatia, to some extent Bosnia, and Montenegro).
  - High levels of public debt increase vulnerability to shocks.
  - In Serbia and Macedonia, fiscal surpluses have only marginally lowered large external imbalances, possibly reflecting large quasi-fiscal activities and dissaving in the non-reformed public enterprise sector.
- Analytical recommendation:
  - Calculate sustainable fiscal positions with various assumptions about private savings, current account deficits, and debt levels.

### Key fiscal and public spending indicators
- Public expenditure share in GDP:
  - Ranges from a low 30 percent in Albania and Romania to over 50 percent in Bosnia and Croatia.
  - Most countries: expenditure levels well above the average of 40 percent of the recent EU members (CEE5).
- Nondiscretionary spending:
  - Accounts for 60–75 percent or more of total expenditures in all but Albania and Bulgaria.
- Public sector composition:
  - Public sector wage bills close to 10 percent of GDP in most SEE countries (except Bulgaria and Romania).
  - Transfers close to 20 percent of GDP in most SEE countries (except Bulgaria and Romania).
- Public investment:
  - About 2–3 percent of GDP in many SEE countries versus 4–5 percent of GDP in the three more advanced EU accession countries.
- Reform priorities:
  - Pension, civil service, and state enterprise reforms to reduce the size of the public sector and create room for pro-growth spending.
  - Well-targeted safety nets to assist those adversely affected by transition.

### Tax policy, revenue issues, and trade-related adjustments
- VAT and tax composition:
  - All countries have introduced the value-added tax (VAT); Bosnia introduced VAT in January 2006.
  - Shift towards indirect taxes has improved tax system efficiency; direct taxes now amount to 40–50 percent of total tax collection in many countries.
  - Corporate and personal income taxes have been reduced in many SEE countries to the lowest levels in Europe.
- Labor taxation:
  - Labor taxation in SEE is relatively high, ranging from 35 to 50 percent of wages.
- Revenue administration:
  - Reforms in revenue administration would boost tax productivity.
  - Bulgaria and Romania have unified collection of various social security contributions.
- Trade and excise changes under accession:
  - Stabilization and Association Agreements imply changes in tariff structures and excises as external tariffs are aligned towards EU levels.
  - Liberalization will boost competition but lower collection from trade taxes.
  - Adoption of EU levels of excises on alcoholic beverages, tobacco, energy, and electricity will in most cases imply increases in these taxes and more revenues from this source.
  - Gradual decline in grants in some countries poses a challenge for revenue collection.

### Fiscal strategy, transparency, and program design
- Recommended actions:
  - Develop medium-term macroeconomic and fiscal frameworks aligned with each country’s macroeconomic situation and policy priorities.
  - Identify a sustainable fiscal path and the reforms needed to achieve it.
  - Reinforce fiscal transparency.
  - Incorporate these issues into Pre-Accession Economic Programs as accession advances.

### Conclusions and policy implications
- Overall assessment:
  - Most SEE countries are still years away from EU accession and need substantial progress in establishing functioning market economies and solidifying macroeconomic stability.
  - Slow structural reform is reflected in low levels of FDI and may limit medium-term growth and real convergence.
  - Macroeconomic stability is essential and increasingly important in the last stages of accession (decisions on ERM2 and meeting the Maastricht criteria).
- Bulgaria and Romania:
  - Both have large external imbalances and inflation well above Maastricht levels.
  - Economies may be vulnerable to external shocks such as large capital inflows.
  - Price pressures from administrative price adjustments and the Balassa-Samuelson effect complicate inflation dynamics.
  - Bulgaria (currency board) may be closer to meeting conditions for monetary union membership than Romania, where inflation is still close to double digits.
- Other SEE country challenges:
  - Sustainability of monetary frameworks.
  - Risks from rapid financial deepening and high euroization that weaken monetary policy transmission.
  - Need for fiscal consolidation to support growth and stabilization.
- Financial and fiscal priorities:
  - Rapid credit growth, especially in foreign currency, pressures external balances and inflation dynamics and challenges supervisory capacities.
  - Fiscal policy priorities:
    - Lower public spending and increase the share of pro-growth spending.
    - Lower labor taxes to boost private-sector-led growth.
    - Main fiscal adjustment should come from reducing large public sector wage bills, subsidies, and transfers via civil service, pension, health care reforms, and enterprise restructuring.
- Research needs:
  - Further detailed work is needed on competitiveness, monetary policy transmission and effectiveness, inflation dynamics, and sources and determinants of growth and productivity.

*Source: _wp0640 - 6.4 percent.*

### References..............................................................................................................

### _wp0640 - References.............................................................................................................................. 25

### Tables
- 1. EU Accession Status of the SEE Countries ................................................................. 5
- 2. SEE: Indicators of the Investment Climate, 2004...................................................... 10
- 3. Financial Sector Indicators in 2004 ........................................................................... 11
- 4. SEE: Summary of Monetary Policy Frameworks...................................................... 14
- 5. SEE: Main Fiscal Indicators, 2004 ............................................................................ 20
- 6. Selected Statutory Tax Rates—New EU Members and SEE Candidate Countries,  
            2004............................................................................................................................ 22

### Figures
- 1. SEE: Indicators of Transition in 2004 ......................................................................... 8
- 2. SEE: GDP Growth, Average 2000-05 ......................................................................... 9
- 3. SEE: Macroeconomic Indicators, 2004 ..................................................................... 13

*Source: _wp0640 - References (page listing of tables and figures).*

### 4. SEE: Competitiveness Indicators, 2000-04 ............................................................... 16

### 4. SEE: Competitiveness Indicators, 2000-04

### Introduction: accession goals and convergence trade-offs
- EU accession requires meeting economic, political, and legal criteria; economic criteria emphasize a functioning market economy and the capacity to cope with competitive pressure and market forces within the Union.
- Formal accession places more weight on transition reforms (real convergence) at early stages and on macroeconomic stability and nominal convergence (inflation, fiscal deficits) closer to membership and euro adoption.
- Real and nominal convergence are closely linked and can pose trade-offs:
  - High investment and productivity growth needed for real convergence can be associated with higher inflation and current account deficits.
  - The Balassa-Samuelson effect (BSE) and administrative price adjustments can raise inflation during real convergence.
  - Capital inflows that finance investment can expand money supply and challenge inflation/competitiveness unless sterilized.
  - Disinflationary policies to meet Maastricht inflation targets can slow growth in the short run.
- The paper reviews progress with real and nominal convergence in SEE and macroeconomic challenges on the path to EU membership.

### Status of EU accession in SEE
- SEE countries differ markedly in accession stages; examples from the text:
  - Bulgaria and Romania are close to joining the EU in 2007 or 2008 after five years of negotiations.
  - Croatia applied for membership in 2003; negotiations started in 2005.
  - FYR Macedonia was given applicant status in 2005.
  - Albania has been negotiating an SAA since early 2003.
  - Bosnia’s 2003 feasibility study indicated more progress was needed; police reform achieved in 2005.
  - Serbia and Montenegro’s 2005 feasibility study was positive; SAA negotiations initiated in October 2005.
- Practical implications:
  - Early-stage countries remain far from functioning market economies and may take years to move from feasibility study to membership application.
  - Macroeconomic stability benchmarks are looser early in the process; examples: Romania declared a functioning market economy despite high inflation; Bulgaria and Romania despite current account imbalances; Croatia despite fiscal deficits.

### Progress in establishing a market economy and real convergence
- Indicators show substantial progress is still needed across much of SEE to become functioning market economies:
  - EBRD transition index measures progress on a scale from 0 to 4.
  - Many SEE applicants’ index levels in 2004 correspond to Bulgaria in 1997–98 or Czech Republic in 1992.
- Private sector size and output recovery:
  - Small private sector shares correlate with slower transition; Serbia, Montenegro, and Bosnia had private sector shares around 50-55 percent of GDP in 2004.
  - Output recovery since 1989 is weaker in SEE relative to other European transition countries.
- Risks to growth sustainability:
  - If structural reform remains slow, positive growth rates observed since 2000 may not be sustainable.
  - Critical reform areas: further privatization (especially large-scale), better investment frameworks, hardening budget constraints, financial sector restructuring.
- Privatization and enterprise sector:
  - Large-scale privatization is behind in several SEE countries; Bulgaria, Romania, and Croatia broadly finalized small- and large-scale privatization, but others lag.
  - Serbia has not seriously restructured/privatized large state enterprises; subsidies and arrears keep loss-making entities afloat, contributing to negative value-added and dissaving.
- Investment climate and FDI:
  - Business environment barriers remain; establishment of a company can take about 50 days in some SEE countries.
  - Corruption and governance problems persist, reflected in poor Corruption Perception Index scores.
  - FDI inflows modest at or below US$500 per capita for much of the region; Croatia highest at US$2,106 per capita (table data context).
  - Investment/GDP ratios:
    - Croatia: over 30 percent
    - Many countries: about 20–25 percent of GDP
    - Serbia and Montenegro: 18 percent of GDP in 2004
- Financial sector reforms and risks:
  - Foreign presence in banking increased; nearly all banking assets private or foreign in Albania, Bosnia, Bulgaria, and Croatia; Romania and Serbia around 50-60 percent private bank asset share.
  - Credit-to-GDP ratios in 2004 ranged from 10 percent in Albania to 60 percent in Croatia.
  - Rapid deposit growth and lending booms are evident; nonperforming loans (NPLs) generally low except in Serbia.
  - Risks: credit primarily finances imports, much lending in foreign currency increases exchange-rate vulnerability, stretched supervision, need to slow credit growth and strengthen prudential rules, high interest spreads indicate need for more competition.

### Nominal convergence — monetary and fiscal frameworks and stabilization
- General observations:
  - Macroeconomic stability matters at all accession stages and gains importance near ERM2 and euro adoption.
  - Bulgaria and Romania face near-term decisions on ERM2 entry and euro adoption; other SEE countries need policy frameworks to reduce vulnerabilities and support sustainable growth.
  - There are few accession-related restrictions on policy choice; outcomes matter more than specific frameworks.
- Exchange rate anchors and inflation:
  - Most SEE countries (apart from Albania, Romania, and Serbia) have had currency boards or tightly managed floats/pegs.
  - Exchange rate anchors helped lower inflation to low single digits by 2004 in many countries.
  - Albania’s loosely managed float with informal inflation targeting via money growth targeting also kept inflation low; Romania’s inflation remained close to double digits in 2004.
  - Serbia shifted between nominal and close-to-real exchange rate targeting since 2000; regime shifts affected credibility and contributed to growing euroization.
- Monetary policy frameworks in SEE (summary from Table 4):
  - Albania: Loosely managed float, Euro reference currency; Informal inflation targeting via money growth targeting; Moderate capital controls.
  - Bosnia: Currency board with Euro peg; Exchange rate anchor; Low capital controls.
  - Croatia: Tightly managed float, Euro reference currency; Exchange rate anchor; Moderate capital controls (detailed limits on portfolio, outflows, bonds, etc.).
  - Macedonia: De facto peg to Euro; Nominal exchange rate anchor; Moderate capital controls.
  - Montenegro: Euro; Exchange rate anchor; Low capital controls.
  - Serbia: Tightly managed float; Exchange rate anchor; Moderate capital controls (detailed restrictions).
  - Bulgaria: Currency board; Exchange rate anchor; Low capital controls.
  - Romania: Managed float, reference Euro; Flexible inflation targeting; Low capital controls (some controls on real estate and non-resident purchases until 2006).
- Competitiveness and real appreciation risks:
  - Fixed or near-fixed exchange rates can cause unsustainable real appreciation unless fiscal and incomes policies are tight and structural reforms boost productivity.
  - Largest current account deficits occur in countries with least progress on structural reforms (Serbia, Montenegro, Bosnia, potentially Macedonia).
  - Structural reform progress alleviates external imbalances by boosting export supply and import substitution.
  - Remittances around 10–20 percent of GDP; capital inflows, FDI, and private foreign borrowing have increased.
- Competitiveness indicators (2000–04) and data caveats:
  - Wage and productivity data for 2004 indicate potential competitiveness problems in Croatia and Macedonia (data subject to measurement problems).
  - EU export market shares suggest Macedonia may have lost competitiveness; most others increased share in EU market.
  - Real effective exchange rates (REER) show large appreciation in Bulgaria, Romania, and Albania in recent years; REERs relatively flat for the remainder of SEE.
- Lessons from recent new EU members:
  - Monetary regimes during accession varied widely: some moved from exchange-rate-based stabilizations to more flexible frameworks as transition advanced; others maintained currency boards successfully.
  - Sustainability of exchange rate anchors depended on structural reform progress, prudent fiscal policy, and strong financial supervision.
- Policy implications for SEE exchange rate anchors:
  - With slow structural reform, soft pegs carry increased risk of lost competitiveness and vulnerability.
  - Bosnia (currency board) and Montenegro (euro) may need tighter fiscal and incomes policies to maintain competitiveness and current account sustainability.
  - Serbia and Macedonia face risks if incomes policies are loosened or reforms fail to boost productivity despite tight fiscal policy.
  - Croatia’s exchange rate anchor and fiscal deficits could threaten competitiveness if capital inflows or tourism-related inflows lead to real appreciation (note: Croatia’s current account deficit declined in 2003 and 2004).
- Constraints on moving to more flexible regimes:
  - High euroization complicates shifts to more flexible policy (e.g., Serbia and Croatia euroization of deposits at 70 percent and 87 percent, respectively).
  - Underdeveloped financial markets and limited interest rate transmission reduce scope for independent monetary policy and may increase exchange rate volatility.
  - Underdeveloped capital markets and maintained capital controls limit speculative attack risk for now, but this may change as markets deepen.
- Maastricht criteria for euro adoption (as listed in the text):
  - Inflation – lowest 3 EU members plus 1.5 percent during one year
  - Fiscal deficit – below 3 percent of GDP
  - Public debt – below 60 percent of GDP
  - Long-term interest rates – below average of the three low inflation countries plus 2 percent
  - Exchange rates – within the EMS band (+/- 15 percent) for 2 years with stability around the central rate
- Bulgaria and Romania specific assessment:
  - Both meet Maastricht fiscal targets; Romania remains far from the inflation target.
  - Bulgaria’s currency board and relatively low inflation make ERM2 entry easier than for Romania, but both must be ready to handle large and volatile capital inflows or external shocks that could test stability.

*Source: 4. SEE: Competitiveness Indicators, 2000-04 (PDF chapter).*

### 6.4 percent.

### 6.4 percent.

### Monetary policy and external sector risks
- Shift in August 2005 to an inflation targeting framework and further opening of the capital account led to important speculative capital inflows that complicated monetary management and forced the central bank to intervene in the foreign exchange market to avoid excessive real appreciation and competitiveness problems.
- Dealing with these shocks may require:
  - further flexibility from fiscal policy;
  - continued strengthening of the financial sector;
  - prudence with monetary management.
- Disinflation can be complicated by real appreciation from the Balassa-Samuelson effect:
  - Estimated Balassa-Samuelson effect have ranged around 0.2–2 percent per annum on average in the recent EU members (Mihaljek and Klau 2004).
  - Together with potential adjustments to administrative prices, inflation may remain well above that required by the Maastricht criteria for some time.
  - The BS effect is an equilibrium phenomenon and should not be suppressed by tighter demand management policies if properly identified.
- Close monitoring and analysis of REER movements is important in the convergence process.
- Entry into ERM2 may not be desirable until basic transition reforms are more advanced.

### Fiscal policy challenges and priorities
- Fiscal policy roles:
  - Support nominal and real convergence in accession countries.
  - With exchange rate anchors, be flexible enough to handle external and internal shocks to ensure external balance and low inflation.
  - Support real convergence and sustainable growth.
- Country-specific observations:
  - Most SEE countries are still far from needing to meet the Maastricht criteria; apart from perhaps Romania and Bulgaria, near-term Maastricht compliance is not a primary concern.
  - Romania’s challenge: raise more revenues to provide room for further fiscal consolidation and EU-related expenditures; current low revenue-to-GDP ratio is 29 percent of GDP.
- Fiscal positions and vulnerabilities:
  - Some SEE countries have relatively large deficits of around 2–5 percent of GDP (Albania, Croatia, to some extent Bosnia, and Montenegro).
  - High levels of public debt increase vulnerability to shocks.
  - In Serbia and Macedonia, fiscal surpluses have only marginally lowered large external imbalances, possibly reflecting large quasi-fiscal activities and dissaving in the non-reformed public enterprise sector.
- Recommended analytical approach:
  - Calculate sustainable fiscal positions with various assumptions about private savings, current account deficits, and debt levels.

### Key fiscal and public spending indicators (selected)
- Public expenditure share in GDP:
  - Ranges from a low 30 percent in Albania and Romania to over 50 percent in Bosnia and Croatia.
  - Most countries: expenditure levels well above the average of 40 percent of the recent EU members (CEE5).
- Nondiscretionary spending:
  - Accounts for 60–75 percent or more of total expenditures in all but Albania and Bulgaria.
- Public sector composition:
  - Public sector wage bills close to 10 percent of GDP in most SEE countries (except Bulgaria and Romania).
  - Transfers close to 20 percent of GDP in most SEE countries (except Bulgaria and Romania).
- Public investment:
  - About 2–3 percent of GDP in many SEE countries versus 4–5 percent of GDP in the three more advanced EU accession countries.
- Pension, civil service, and state enterprise reforms are needed to reduce the size of the public sector and create room for pro-growth spending.
- Well-targeted safety nets are important to assist those adversely affected by transition.

### Tax policy and revenue issues
- VAT adoption:
  - All countries have introduced the value-added tax (VAT); Bosnia introduced VAT in January 2006.
- Tax composition and rates:
  - Shift towards indirect taxes has improved tax system efficiency; direct taxes now amount to 40–50 percent of total tax collection in many countries.
  - Corporate and personal income taxes have been reduced in many SEE countries to the lowest levels in Europe, limiting scope for further cuts.
  - Labor taxation in SEE is relatively high, ranging from 35 to 50 percent of wages; reductions would help job creation and reduce informality.
- Revenue administration:
  - Reforms in revenue administration would boost tax productivity.
  - Bulgaria and Romania have unified collection of various social security contributions; some countries could consider merging social contributions with broader tax collection in the longer run.
- Trade and excise changes under accession:
  - Stabilization and Association Agreements will imply changes in tariff structures and excises as external tariffs are aligned towards EU levels.
  - Liberalization will boost competition but lower collection from trade taxes.
  - Adoption of EU levels of excises on alcoholic beverages, tobacco, energy, and electricity will in most cases imply increases in these taxes and more revenues from this source.
  - Gradual decline in grants in some countries poses a challenge for revenue collection.

### Fiscal strategy and transparency
- SEE countries should develop more detailed fiscal strategies with clear medium-term priorities:
  - Develop medium-term macroeconomic and fiscal frameworks aligned with each country’s macroeconomic situation and policy priorities.
  - Identify a sustainable fiscal path and the reforms needed to achieve it.
  - Reinforce fiscal transparency.
  - Incorporate these issues into Pre-Accession Economic Programs as accession advances.

### Conclusions and policy implications
- Most SEE countries are still years away from EU accession and need substantial progress in establishing functioning market economies and solidifying macroeconomic stability.
- Slow structural reform is reflected in low levels of FDI and may limit medium-term growth and real convergence.
- Macroeconomic stability is essential and increasingly important in the last stages of accession (decisions on ERM2 and meeting the Maastricht criteria).
- Bulgaria and Romania face significant challenges before meeting Maastricht criteria:
  - Both have large external imbalances and inflation well above Maastricht levels.
  - Economies may be vulnerable to external shocks such as large capital inflows.
  - Price pressures from administrative price adjustments and the Balassa-Samuelson effect complicate inflation dynamics.
  - Bulgaria (currency board) may be closer to meeting conditions for monetary union membership than Romania, where inflation is still close to double digits.
- Other SEE countries face challenges with:
  - Sustainability of monetary frameworks;
  - Risks from rapid financial deepening and high euroization that weaken monetary policy transmission;
  - Need for fiscal consolidation to support growth and stabilization.
- Rapid credit growth, especially in foreign currency, pressures external balances and inflation dynamics and challenges supervisory capacities.
- Fiscal policy priorities:
  - Lower public spending and increase the share of pro-growth spending.
  - Lower labor taxes to boost private-sector-led growth.
  - Main fiscal adjustment should come from reducing large public sector wage bills, subsidies, and transfers via civil service, pension, health care reforms, and enterprise restructuring.
- Further detailed work is needed on competitiveness, monetary policy transmission and effectiveness, inflation dynamics, and sources and determinants of growth and productivity.

*Source: _wp0640 - 6.4 percent.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp0640.pdf_