Transcript of an IMF Press Conference: From Transition to EU Membership -- The Challenges in Developing Macroeconomic Frameworks

September 22, 2000

Friday, September 22, 2000

Peter Keller, Assistant Director, European II Department
Roger Nord, Senior Resident Representative, Czech Republic and Hungary
David Robinson, Assistant Director, IMF Research Department
Max Watson, Senior Advisor, European I Department
Kathleen White, Senior Press Officer, External Relations Department

Ms. White: Good morning. Thank you for coming to this press briefing on Central Europe, "From Transition to European Union Membership: The Challenges in Developing Macroeconomic Frameworks." My name is Kathleen White. I'm with the International Monetary Fund Media Relations Office. Before introducing the panel, let me call your attention to the publications at the back of the room on the table. We are fortunate to have here to answer your questions the authors or coauthors of almost all of the four publications at the back table.

First of all, I am very pleased to introduce to you, on my right, Max Watson. He's a Senior Advisor in the European I Department of the IMF. He coordinates cross-country issues, including those related to transition economies, and has particular experience working with the countries of Central and Southeastern Europe. He's the coauthor of one of the articles at the back of the room. That article can be found in the Finance and Development magazine. The subject of the article is "Central Europe: From Transition to EU Membership."

On Mr. Watson's right is Roger Nord, who may be familiar to some of you. He's the IMF Senior Resident Representative the for Czech Republic and Hungary. He's the author of a second article to be found in the Finance and Development magazine. That article is on Central and Eastern Europe and the new financial architecture.

Next to Mr. Nord is Peter Keller, the Assistant Director in our European II Department, working with the Baltic Division. I believe he has just come to Prague directly from Tallin. Mr. Keller is the coauthor of the policy discussion paper at the back of the room, which is entitled "Pros and Cons of Currency Board Arrangements in the Lead-Up to EU Accession and Participation in the Euro Zone."

I will mention an additional, a fourth paper at the back of the room, which is entitled, "Exchange Rate Regimes in Selected Advanced Transition Economies: Coping with Transition, Capital Inflows, and EU Accession."

Joining us shortly, also, will be David Robinson, Assistant Director of the IMF Research Department. He heads the team that produces the World Economic Outlook (WEO), and I will call your attention to Chapter 4 in that publication, which is on the "Accession of Transition Economies to the European Union: Prospects and Issues."

This briefing is on the record, and before we open to questions, I believe that Mr. Watson will have some remarks to make, as will others on the panel.

Mr. Watson: Thanks very much, Kathleen. The World Economic Outlook, Chapter 4, talks about the accession processes being a driving force and an anchor for economic reforms, but it also underscores that the applicant countries will face a number of tensions and challenges as they go through this process, that fiscal policy will have to cope with reform costs and infrastructure needs, that monetary policy will face uncertainties in capital flows, and that the financial sector supervision will need to be implemented effectively as liberalization proceeds.

These publications are a spin-off from the Fund's work program in this area, and let me give some advance billing to one other paper that is coming around the end of the year. We are, I hope, putting out an occasional paper focused particularly on the Central European countries, but with probably some interesting messages and thoughts for other transition economies, on trying to make links between the conversion process and the macroeconomic policy challenges for these countries.

Let me perhaps just, as an introduction, highlight two or three themes that come out of the publications at the back of this room, and informed a bit also by our ongoing research to the occasional paper that's forthcoming, and then listen to your questions, some of which I hope we can respond to, and others of which may help us as we're defining topics that will be interesting as we finalize that occasional paper.

In this work, I think we are guided by probably two lessons from the past decade that seem to me fundamental. The first is that the countries that have succeeded rather well in the transition have not only had good macroeconomic policies, they have also given great attention to the structural reforms that underpin those macroeconomic policies-things like the hard budget constraint and the enterprise sector and cleaning up the banking system. That is one lesson that is guiding our research. We try to look at the structural underpinnings of macroeconomic reform.

The second lesson is that there is no message from the past decade in favor of a "cookie-cutter" approach. It is not "one size fits all." You have only to think of two of the leading cases, Hungary and Poland, in the way they approached the transition process, with macro shock therapy in Poland, but structural and privatization shock therapy in Hungary; Poland reducing its debts, Hungary managing to cope with its debt load in the context of rapidly growing exports; and both countries managing to impose a hard budget constraint through the banking system in different routes. So there is divergence but also some common themes.

In these publications and in our work program I think the first message I would like to highlight is that we need to understand the convergence process. We cannot just lacquer on, paint on, macroeconomic policy frameworks on to these economies, which are changing rapidly.

There are probably at least three key elements of the convergence process that pose a challenge for macroeconomic policies. One obvious one, with the lessons of other emerging market countries as well, is that these countries will experience at times strong and variable capital flows. The capital inflows have to be good news. Managing them will be a challenge for macroeconomic policies.

Second is the lesson from the most successful transition economies, and from Western Europe in its stage of convergence in the post-war period, is that productivity growth will probably be key, as important as investment levels. This has messages for corporate governance, for banking reform, for hard budget constraints. But at the same time there is some uncertainty about how much investment ratios will need to increase, and in some of the countries investment at times has increased well ahead of domestic savings. A number of the leading accession candidates had current account problems, but we have seen recently, for example, in Estonia and Hungary, how strong export growth has brought them to manage those problems. But as convergence takes place, whatever the role of productivity, rising investment will at times potentially cause balance of payment stresses.

The third by-product of the convergence process, which is mentioned in the WEO and is of a more technical nature, is that when productivity growth in the traded goods in the exporting sectors is very rapid, it may cause higher consumer price inflation or appreciating exchange rates. In other words, these countries' real exchange rates will tend to appreciate. That may cause a tension between the goals of price stability and exchange rate stability, although research in the Fund is suggesting that that tension can be exaggerated. It may be a modest tension. This is talked about in the WEO. If the room is interested in that, I will come back to that rather technical subject in the questions.

So, the first message is understand real convergence and what it means, and the second message, in fiscal policy, is that effective public expenditure management is absolutely critical to make room for growth. Why are public expenditure management and reform so important? If you think of the pressures that fiscal policy is going to face-they are mentioned in the World Economic Outlook chapter, and they are also one of the central subjects in the Finance and Development article that Bob Feldman and I wrote-because of balance of payments pressures, there is a need to keep a firm hand on fiscal deficits. Typically in these economies it is the balance of payments, not the public debt, that will constrain fiscal policy.

At the same time, tax burdens are high. If you look across, for example, the countries in Central Europe, typically income tax burdens, and especially social security contributions, are very high. Even by West European standards, they are quite high. They fall on labor income and they need to be reduced. So that is another tension for fiscal policy.

Finally, and most obviously, as is discussed in the WEO, there are substantial pressures to raise public spending on infrastructure, to meet also accession costs, to handle reform costs. So all of these pressures mean that fiscal policy will need to identify and reform the elements of current public spending that are relatively high, targeting transfers, reforming central governments, reforming health care systems. This is necessary because, unless public expenditure is well managed strategically, when there are crises or when there are pressures on the balance of payments, it will tend to be investment that is cut. So to handle uncertainty, managing current spending and reforming it is critical.

Monetary policy, too, will face the challenge: how do you set an anchor for expectations, for stability, but also handle uncertainty. I think it's clear that the central banks in the transition economies on their way to accession will face turbulent waters at times. If you look at their exchange regimes at the moment, you see a range of regimes, from currency boards to pegs, to crawling pegs, to free-floating and inflation targeting. To some degree-and one of the working papers looks at that question of different exchange regimes-to some degree, these different regimes do fit with the fundamentals of the countries. But there is a general drift toward more flexibility, except for countries with currency boards. Why? Because of the need to handle capital flows, particularly. Flexible regimes can discourage speculative attacks, and they can encourage hedging by private sector agents' banks and firms. So, apart from the hardest pegs, we will see a drift toward flexibility.

My last message on monetary policy is that flexibility is not a solution to all problems. There is a limit to what you can ask central banks to achieve unaided. A strong and relatively flexible fiscal policy will be critical in handling capital flows. Also, a sound financial system can help filter capital flows and avoid some of the more distortive kinds of capital flows. Of course, a sound financial system can also help support growth and play a key role in avoiding the development of dual economies. In several of these advanced transition economies we see foreign direct investment coming in strongly; we see strong growth in parts of the economy. But we see the domestic sector and small and medium-sized enterprises lagging. An effective financial system, not just banks, but securities markets too, can help avoid the development of dual economies.

I'm going to stop there. But when I look back at these challenges we're talking about, just a word to put them in perspective. These, in the most advanced cases, are really analogous to challenges that the present EU members faced on their own path in the last few decades. Think of the difficulties they faced meeting Maastricht criteria; think of their difficulties in managing the exchange rate mechanism of the European monetary system. Think, also, of countries like Hungary or Poland who have made more progress in pension reform than some members of the European Union. You realize these are very manageable challenges, tough, but not obstacles, to an early movement toward accession.

Thank you, Kathleen.

Ms. White: Roger.

Mr. Nord: Thanks, Kathleen. I'm going to briefly speak to the issue of the new financial architecture standards, codes, transparency, how this affects and will affect Central Europe and put that in the context of the overriding political objective for the countries in Central Europe, which is EU accession. Since the emerging market crises of the 1990s, there has been an active discussion on how to make the international financial system more resilient to shocks. Strengthening the international financial architecture has been the buzz word. There are various facets to this as you know. I'm going to concentrate on those aimed at crisis prevention and how the IMF together with the countries in Central Europe has been working on that over the last couple of years.

One conclusion from the lessons of the crises is that transparency is a very important virtue. Transparency both of economic policymaking of countries as well as transparency on the side of the IMF and other advisors. But transparency alone is not enough. You need a yardstick, if you will, a benchmark to measure all this information against. And that's where standards come in.

Financial markets like to know whether countries' practices conform to international standards and if they don't, they would like to know where these practices fall short of international best practice. The IMF has responded to this need in several ways. On the transparency side, we have encouraged countries to publish reports prepared by the IMF in the context of its Article IV surveillance, as well as the commitments that countries enter into under programs, be it letters of intent or memorandums of economic and financial policies.

The IMF now strongly encourages that these documents be published and, in the case of Central Europe, countries have over the last couple of years moved very decisively in that direction. Here in the Czech Republic, as you probably know, the staff report for the Article IV consultation for the year 2000 was published last month.

On standards, the IMF has developed and disseminated some of the standards in our core areas of responsibility. I'm thinking here of economic statistics, publication practices, fiscal transparency, where the IMF together with member countries has developed a code of good practice if you will, and also in the area of monetary and financial policies. There are other standards where the core competency lies with other agencies, and together with the Basel Committee and its core principles, the IMF has in its assessment of country practices drawn on those outside agencies.

How has this all been brought together? Well, for the past 18 months or so, nearly two years probably, we have been engaged in a process of preparing reports on the observance of standards and codes, reports that take international standards and then discuss country practices and access to what extent these country practices meet those standards. Again for the Czech Republic, for example, such a report was done in September of 1999 across a variety of areas, and this report is public. It's available on our web site.

A second strand that has been very important in the strengthening of the international financial architecture is the focus on domestic financial systems as a key element, both in terms of transmitting the crisis from one country to another in the process of contagion but also in terms of the ability of domestic financial systems to be resilient to shocks and in terms of vulnerability to such shocks.

The IMF and the World Bank have developed together a joint initiative called the Financial Sector Assessment Program (FSAP). It should be understood as a sort of very in-depth audit, if you will, of the financial system, not just the banking system but also other elements of the financial system-insurance companies, pension funds, the payment system-and of course also supervision of the financial system. These reports have various components, some very detailed technical components, but also include an analysis of how vulnerable the financial system is, how stable it is. This is the element that the IMF in particular concentrates on. And from the World Bank's angle, the reports look at where does the financial system need development, what are its structural shortcomings, et cetera?

How important is this work for Central Europe? Well, I think it's important for Central Europe, particularly for two reasons. First, countries in Central and increasingly in Eastern Europe are increasingly integrated with the world economy, not just in trade, but in capital flows, as Max was just illustrating. A number of countries attract large amounts of foreign direct investment but also portfolio investment, and for financial investors as well as for direct investors, the fact that these economies, many of which are new to investors, have structures that can give confidence and that can withstand shocks is an extremely important element. And importing such confidence by adopting international standards and best practices is clearly one way to go about it in a way that Central European countries have embraced.

Second, and maybe this is a link with the topic today, the overriding political objective here in Central Europe is EU accession. It's the top of the agenda both in the political and in the economic arena. And a key aspect of EU accession, as you know, is the adoption of reams of EU law, known as the aquis communitaire. A number of countries have made substantial progress in that direction, and the adoption of international standards in the economic area is really very much complementary to that process. We have close contacts with the EU and work a lot on these areas, because to the EU, of course, it's equally important that the countries or future members of the EU have a financial system that has stable characteristics.

So in that sense, the standards and codes and the adoption of international best practice is really another building block on the international credibility of Eastern and Central Europe. I'm going to stop there for the moment and pass on the mike to Peter Keller.

Mr. Keller: Thank you. I'll be very brief. Mr. Watson and Mr. Nord covered basically what I wanted to say. Perhaps just one thing. When we think about accession countries to the EU, most of us think in terms of Poland, Hungary, Czech Republic, but up there in the north are the three Baltic states, who emerged after the breakdown of the Soviet Union, and indeed Estonia, for example, was in the first wave while Latvia and Lithuania are in the second wave Just to give an example of Estonia, in terms of opening and closing chapters on the aquis communitaire, a tremendous amount of progress has been made and all three Baltic countries are extremely eager to join the European Union and also to introduce the European currency. They are extremely enthusiastic about it. In the case of Estonia, we have already a country that is pegged to the euro because it used to be historically pegged to the deutsche mark for the last eight years and so here the authorities aim at a very smooth transition after, of course, after joining the European Union into the euro area.

Now, interestingly enough, all three Baltic countries have fixed exchange rates, but they have three different pegs. Latvia is pegged to the SDR currency basket and, of course, at some stage in the process of joining the European Union or shortly thereafter, but certainly before joining the ERM, it will have to go over to a euro peg. And similarly, Lithuania right now is pegged to the very strong U.S. dollar. This is one of the reasons why development in the Baltics is slightly different since it's much easier for country like Estonia to register high rates of export growth-about 50 percent in the first half of this year-because it's pegged to the euro. while countries who do not have this advantage have somewhat lower but still fairly impressive growth rates. So those countries are converging very rapidly and, of course, their hope is that they will not be forgotten although they are geographically small and their populations are small and, of course, naturally the focus is mainly on the very large countries in Central Europe. But here are three countries that in many respects are close to completing any requirements you can think of for EU membership. Thank you.

Ms. White: The panel will be happy to take your questions now. I would like to ask you, please, to wait for the microphone and kindly state your name and affiliation. And if you wish to direct your question to a particular panelist, feel free, please.

Questioner: [Inaudible]-the countries of Southeastern Europe, Romania and Bulgaria. They're having a hard time to join the European Union. Their economic situation isn't the rosiest. Sanctions on Serbia haven't really helped much since the Kosovo War. Could you perhaps give us an assessment of what their prospects are for joining the European Union within in some reasonable time frame? Thank you.

Mr. Watson: Let me have a first shot at that maybe. One of the great changes in the accession scene in the past year has been the adoption of what the Union calls the Regatta Principle, which meant that rather than having one wave of frontrunner applicants, you had a group of 12 or 12 plus Turkey. And when you look at the Southeast European economies, it's quite clear that there is scope for them to advance rapidly. The case that probably is a particularly good illustration is Bulgaria, where you have a very effectively functioning currency board, which has helped get macroeconomic stabilization into place, where there has been a good deal of privatization and reform in the enterprise sector, which now is moving on and needs to move on to utilities, and so forth. They still have a little way to go on getting the banking system to be truly effective in intermediating credit flows. But Bulgaria is probably a good example of a country where five years ago, people would have wondered which way will it go and now it's very clearly converging toward the accession process. It's probably the best example.

If there are, what, one or two priorities that those countries need to focus on, overwhelmingly the first is the issue I was mentioning in connection with some of the accession frontrunners: sorting out the hard budget constraint on enterprises so as to address problems of wage levels that aren't in line with productivity and of payments arrears, whether to the budget or to other enterprises. These are some of the problems that Romania has struggled with repeatedly, for example. And the second priority, which is related to the first, is the functioning of the judiciary and the legal system, in other words, implementation of regulations, supervision, legal enforcement. That's a problem. I mean, throughout the accession countries, that is one of the hardest parts, I think. Even in the most advanced cases where the aquis communitaire has been in one sense implemented, in another sense, the court systems are struggling to keep pace and to make sure that the legal system is giving full support.

So I think that question for Southeastern Europe is particularly acute. Getting hard budget constraints on enterprises and an effectively functioning financial system and making sure that legal implementation and the rule of law are in the saddle.

But the door has been opened and I think that's a big incentive for the countries to move ahead and cease the opportunity to these links. One of the biggest advantages for all of the countries is not just a question of trade access or foreign direct investment. It's the policy leverage that you get by linking in the long run to the European Union. Let me stop there because I also noticed that David Robinson has joined us. And in confidence, I didn't anticipate your remarks, David.

Mr. Robinson: Thank you, Max. And I'm sorry to be late. I was held up in another meeting, I'm afraid. I assume since I wasn't here that Max and Roger have covered the macro and financial sector issues and I'm sure you want to get to questions. So I will be very brief.

I've been asked to talk about three structural issues: the institutional challenges faced by the EC accession countries, the impacts of accession on labor markets, and the reforms that the EU itself must undertake to accept new members.

So I will just make a couple of very brief remarks. As we discussed in the recent WEO, it's true the accession countries have made a lot of progress in a number of dimensions of transition. And the EU Commission itself has said that six countries are now regarded as having market economies. Two of them are close. Two others have somewhat further to go. And as Max was just saying, the area where most needs to be done now is really on the institutional side, not just in setting up the institutions and putting in place the laws, but in the implementation of those laws, strengthening enforcement, developing the judicial system, and in a number of cases attacking issues of graft and corruption as well. On the labor market, this is obviously a concern for both the EU and the accession countries.

In brief, the accession countries, which are continuing to undergo a lot of structural change, will need to keep their markets as flexible as they can in the negotiations adopting the labor market chapter of the aquis. For the EU, of course, the concern is whether will be large-scale migration of unskilled labor, which would make life much more difficult and add to unemployment pressures. I think that that concern is probably somewhat exaggerated, and we can discuss that in a little more detail if you like. There will be some regions, however, that will be affected and, once again, there is a need for the EU in this case to look to make its labor markets more flexible so that it can deal with such shocks.

In terms of the other challenges for the EU, obviously, the institutional framework is going to have to be substantially revised. This is under way through the Intergovernmental Conference. We hope that it will be completed by December. There are other very difficult issues, including the implications of enlargement for the common agricultural policy, and of course, the structural funds and the impact on the budget there as well.

Let me just conclude by saying that in the WEO, which is at the back of the room for those of you who don't have it, we ask whether the accession process is going to be prolonged, and if so, whether that will be because the candidates aren't ready for the EU or because the EU isn't ready for the candidates. I think both of them have a lot to do. As Max just said, the desire for EU membership has been a spur for reform in the accession countries, but I think that the desire for enlargement on the part of the EU, which is clearly still there, should be a spur to them to accelerate their own reforms, particularly of labor markets, and these reforms anyway would be desirable regardless of whether there were enlargements or not.

Thank you.

Questioner: I'd like to address this question either to Mr. Keller or Mr. Watson. There is an advisor to Bulgarian President Stojanov in the United States, Professor Steve Hanke, who has recommended in recent days that it would not be wise for Bulgaria to continue with a currency board that is pegged toward the deutsche mark/euro and that it would be more prudent for Bulgaria to peg the lev currency to the dollar in the future. I am interested in what your views are that you would give. This has caused some debate in Bulgaria in the government, and I am interested in what your views are on that, what you would tell the Bulgarian government about such a move, and also what impact such a move might have psychologically on the euro in world markets.

Mr. Watson: Well, Peter may have a few words from his experience in the Baltics. I think that in terms of historical vocation and accession ambitions, the Bulgarian Currency Board is oriented toward new membership and the euro area, and probably that's an overriding perspective that it is hard to think of easy technical reasons to move away from. Also, of course, one of the virtues of currency boards is working well and working stably. In terms of fostering integration in trade flows, I would have thought "If it ain't broke, don't fix it." But Peter, you have had some experience with different pegs you may want to amplify on a little bit.

Mr. Keller: Just a word or two. When Estonia introduced the deutsche mark peg, very little of its trade was with the deutsche mark and very little of its trade was with the euro area, because it still depended very much on trade with Russia at that time, the former Soviet Union countries. So what the deutsche mark peg did was it contributed in our view to the reorientation of trade patterns toward the large industrial, centrally located countries.

I think it is a two-way street. On the one hand, you would like to have a peg to a currency that corresponds to a trade pattern; but at the same time, your currency determines your trade pattern. In gravity models, for those of you who are interested, for example, trade in Canada between provinces very close to the North American border is much more intense than what you would expect. It is about ten times as high as with American states across the river or across the street. So the currency pulls the trade.

I am not an expert on Bulgaria, but I think that a country aspiring to EU membership will at one point have to have a peg to the euro. Now, to go from a euro peg to another peg and then back again does not seem to be the straightest way of proceeding.

Questioner: I would like it, Mr. Robinson, if you could expand a bit on your remark that the fears of large-scale migration might be overdone and that there seems to be a bit of a political impetus behind it in countries like Germany or Austria where you have instances of political misgivings about this. And maybe you could just tell us why is it exaggerated, what do you expect, and what will happen.

Mr. Robinson: Sure. I think that the most careful study that has been done on this was done for the European Commission, and it suggested on the basis of a model that has looked at migration patterns in the past that the likely degree of migration from the Central and Eastern European countries to the EC-and I think you are quite right that it would be concentrated in Germany and Austria, particularly Germany, actually-would be about 335,000 people per annum. When you think of that in terms of a) the stock of people who have emigrated from Central and Eastern Europe to the EU over past years, which I think is about 900,000 or so, and as a percentage of the EU work force, I think it is about 0.1 or 0.2 percent of the EU work force, a flow of 335,000 a year. That, therefore, does not appear to be large. I think the other point-and you also have to recognize this-is that there is a great deal of illegal emigration already, and that is going to happen, I think, regardless of enlargement or not.

That being said, as I also mentioned, I think that there will be some regions, particularly, perhaps, border areas in Austria and Germany and some sectors, which will be more affected, but I don't think the answer is to try to restrict migration, partly because it will happen illegally anyway. I think that the answer instead is to try to make labor markets in both the EU and in the accession countries more flexible so they can manage what would not appear at this stage, based on the best evidence that we have, to be as big a shock as some people would suggest.

Questioner: I wonder if the IMF has any estimates of the costs and benefits of accession that you refer to in general terms, particularly the fiscal adjustments that might be necessary for some of the larger accession countries; possibly also the possibility of higher unemployment as part of that adjustment; and finally, the effect that, after accession, these countries would actually be members of the euro zone might have on their exchange rate and balance of payments situations.

Mr. Watson: Yes. On the fiscal costs, in one of the articles in the finance and development piece on page 26-there is a box on "A Fiscal Case Study: Hungary." It works through an attempt to see how the fiscal stresses work out in Hungary, Hungary being chosen because it is pretty well reformed, it has gotten rid of what we call its quasi-fiscal deficit, its off-balance-sheet elements, largely, and has a fairly transparent fiscal situation. When we did that, one of the things that came to light was, first, that you could get the numbers to add up when you laid in these accession costs that were referred to in that article, and there is also out on the IMF's website a staff country report on Hungary called Hungary: Selected Issues and Statistical Appendix, put out in April of this year, which goes into detailed numbers and talks about how we did our assumptions on these things.

One of the areas that is difficult to handle is environmental costs. The World Bank has done a series of estimates of the present value of environmental costs, well worth looking at, in the transition economies. Depending on how they are paced, the incremental effect on government expenditure could be anything in some of the countries between 1 percent of GDP of public expenditure to 3 or 4 percent of public expenditure in certain years.

So there is a need there to get the priorities sorted out. The EU has gone into accession partnerships with these countries. Those partnerships spell out some of the priorities, including in areas like this. If you look at three different examples of incremental costs there, in some countries-three of them particularly-I think the EU has identified nuclear power as being very, very high priority. That is an area where hopefully, also, they will benefit from quite a lot of foreign assistance in decommissioning of old plants.

A second is making sure that the environmental legislative framework doesn't mean that transition economy firms have an unfair competitive advantage in the single market. Remember, there is no transition period for things that affect competition in the single market. There were transition periods of all sorts of things from shipyards to agriculture, but not on the question of competitive equality in its fundamental sense. So that would be an important element.

But, on the other hand, even in Central Europe, there are areas where water services and sewage are in a desperate state in rural communities. That is a social priority, but the pacing of it may not be as sensitive a matter for the accession process as such. I think this year, as the Union gets into the process of negotiation on transition periods, which hasn't really started yet, there, we are going to see that in environment, agriculture, etc., the numbers are going to surface. It is hard to discuss at the moment with the countries, because they of course don't want to give their negotiating positions in public, and the EU is just grappling with the numbers.

So on the one hand, the numbers suggest if reasonable paced, it is manageable, but they also suggest there is a little bit of a "black box" that needs to get clarified if these countries are to have fully developed fiscal strategies over the next year or so.

Mr. Keller: The other side of the coin is, of course, contributions from Brussels to the countries. The countries will not be left alone to carry this cost. It is very difficult to determine what this will be. Some of the estimates for countries which have a very large agricultural share, like Poland, are very high; for others who have already made a transition, it is less. But I think that, yes, if you are a country that has a nuclear power plant, you do have a problem, but again, your neighbors are likely to chip in. In any case, the EU is prepared, has a number of programs to provide financing, and some of it is also going to be transfers in grant form. Thank you.

Mr. Watson: I failed to come back on another part of your question on unemployment, I realize. There, at a simple level, I'd say no in the sense that I think the unemployment in the transition economies is pretty much largely of the shakeout kind, and therefore, you would expect it to go up before it goes down, and in one or two cases where it didn't rise initially, it meant that it was a problem, not a solution. And accession generally is unemployment reducing.

But there is a particular point there that is more targeted, and that is on the regional issue in these countries. If you look at the last wave of accessions, or let's say the Southern wave-look at a region like Andalucia-basically, the regions of these countries were converging, and the literature tells you in the United States, in Japan, and in Europe, you get very strong regional income convergence over longer periods-about 2 percent a year, or something like that, an almost unbeatable trend-but there are proximity effects, so when the Southern countries joined, the regions closest and most integrated with the EU accelerated sharply, and divergences occurred.

So if you look at Hungary now, the west and north-central part of the country, the labor market is already showing some tensions, and to a lesser degree, that's the case in a number of the other countries that border it. If you look at Poland, you find a very varied labor market response to the integration process. Part of that is a lesson of geography-this question of how many miles are you from Brussels and all-but part of it also needs addressing by policies, because there is a danger of dual economies, not only big and foreign-owned versus SMEs and domestic-owned but also a geographical divergence. And we know from Western Europe that it can be serious, and in terms of unemployment, it can persist. There are countries in Western Europe where unemployment differentials have not narrowed significantly since the oil shocks.

So there are probably two priorities there. It is usually not a labor market policy problem. Countries like Hungary-they range-but countries like Hungary have labor markets that are far more flexible than Western Europe. In others, there are problems of indexation or of benefit systems that don't work. Generally, though, it's not a labor market problem. It is a training problem, certainly, where work forces in some of the regions need to be reconverted and trained. It is also an infrastructure problem. As you see the motorways spread through Central Europe, development goes with them, and that underscores the need to make room for these capital spending programs. I come back to my concern that if current spending isn't reformed properly, every time balance of payments pressures emerge, we are going to see motorways halt. We have seen this in industrial countries, we have seen it in developing countries. Those seem to me among the priorities.

Questioner: I would like to ask you to tell us something about the IMF programs and tools that were given to transition countries in last 20 years. What was the philosophy of giving those programs? And whether the IMF may be satisfied with the effects? Thank you.

Mr. Watson: The classic tool was the stand-by. We've had other forms of involvement that are possible and Roger may say a word about them. The stand-by credits were usually accompanied by quite a strong technical assistance program in areas like monetary and exchange rate policy, banking supervision, public expenditure management, tax policy.

So there was a sort of twin effort to sort out the macro numbers and to move up the structural implementation.

And I think that this worked best where probably three things were going in tandem, if three things can go in tandem. The first was in the classic sense that fiscal deficits were brought down and there was a sensible anchor for the exchange rate that worked.

The second was that there was a really successful effort to stop financing pressures in the larger enterprises, usually of course state-owned, but even when they're privatized, the problems don't always stop, as we've seen in Central Europe. And that was done in different ways. I mean you think about the way that Hungary went about it, it tended to go very strongly for privatization, foreign direct investment, and the banking system. Estonia also-its banking system is now, very, very largely foreign owned and financing, very much foreign direct investment driven now as well. Poland didn't go that route, but it also, by a different approach, managed to impose a hard budget constraint on enterprises and to stop off-budget spending and pressures. And there is an element of politics there; probably there was just a great determination on the part of the government not to bail out.

And the third is to put in place the supports in terms of judiciary, the ones that David was talking about just now, and the anticorruption and the legal implementation measures. It's a hard act to get all of those together and they're not always easy to specify in a single manner and I think the successes have come in different ways.

That was one form of involvement. There are others. Roger may need to add a word there, I think.

Mr. Nord: To come back to your original question, the IMF has in Central and Eastern Europe-I'll leave the Baltics to Peter Keller for a moment-extended financial assistance to all of the countries. With the exception of Slovenia we've been financially involved in all of them. But today, it is Romania and Bulgaria and the financial assistance is no longer the centerpiece of our dialogue with the other Central and Eastern European countries. How was the financing used? Well, in many of those countries, the financial assistance very quickly became precautionary and was not financing the balance of payments but was a signal to the international community that the policies these countries were pursuing had the confidence of the IMF which was the case in Hungary. It was also the case in Poland in the mid-1990s.

But, of course, the financial assistance from the IMF is only one part of what the IMF was doing with these countries during transition. Max mentioned technical assistance. That's been very important and still ongoing in a number of countries. I would mention training, which has also been a very important way in which assistance has been flowing to these countries. And of course, today, the assistance is very much in the surveillance dialogue. The Czech Republic is a good example where the IMF is a continuous dialogue with the Czech authorities on economic and financial policies. There is no need for IMF financing, but there has been a great demand for an exchange of views on what the IMF could contribute to the dialogue here in the Czech Republic on how to get the economy back on an even keel and on a high and sustained growth path. So in that sense, the role of the IMF has really changed over the past decade here in Central Europe from providing financial assistance to all the other aspects that I just mentioned. Peter, you might want to add something on the Baltics.

Mr. Keller: Yes, thanks. It's very similar in the sense that all three Baltic countries have IMF programs, but none of them is actually borrowing under them. They are purely precautionary and we would expect them to stay this way. Again, initially, for a short period when the Fund introduced a special facility, the structural transformation facility, to cope with countries who were not quite ready for stand-by arrangements, the Baltics like all the other countries that had emerged from the former Soviet Union availed themselves. But since then, the dialogue is really that no longer a debtor-creditor dialogue. It is an exchange of views on policies. The government finds it useful also-they told me last week-to have an agreement because it keeps the government coalition together. It keeps the ministers in line saying, you know, this is the plan and you have to fit in, and it also gives the framework over the medium term.

Questioner: My first question is how fast do you believe the Czech Republic can be in reaching the average level of GDP per capita of European Union countries. The second question is about unemployment. Mr. Robinson mentioned the labor market in the European Union and we know that in European Union countries, there is a big core rigidity of labor market compared to the United States, for example. Do you think it will be difficult for us in the future to fight against unemployment entering the European Union and that it will stay around 10 percent?

Mr. Nord: On your first question, let me first disappoint you. I'm not going to give you a number of years that the Czech Republic will need to reach the European Union average, but let me give you two factors that will determine that time period. The first is the starting position and the Czech Republic starts at a level of per capita income that is the highest after Slovenia of the countries in line to join the EU. And that, of course, helps. And the second factor will be the growth rate at which the Czech Republic is able to grow over the next decade. Here I am personally optimistic that the last three years in the Czech Republic, which have seen severe recession, are going to be overcome. Can the Czech Republic start growing at the same rate as Hungary and Poland? My view is yes, it will, but to do so, it will need to complete the structural reforms that this government has now started in the industrial enterprise sector, in the banking sector, and on that basis I'm confident that the Czech Republic can grow as fast as Poland and Hungary.

Mr. Robinson: Maybe I will just add something brief on the labor market issue. I think in negotiating the aquis with the European Union, there are really two types of chapters if you like. There are things like the customs union where fundamentally you just have to adopt the common external tariff and there are others like the labor market chapter where there is the social charter, but where countries have a great deal more flexibility on the policies that they adopt. And while I would not claim to be an expert on the Czech labor market and that would be up to Roger to comment on, my advice to the Czech authorities would be to use all the flexibility that they have in the negotiations on the labor chapter to keep their markets as flexible as they can, not to adopt the worst elements of the European labor markets because if you did, yes, it will be much more difficult to reduce unemployment and I think the experience of East Germany, which did indeed adopt the German labor market system, testifies to that.

Questioner: I'd like to come back to the currency board arrangements. It seems that from the very beginning of the transition period, the IMF was very much behind, you know, introducing of currency board arrangements. So in some cases, it worked. In some cases like Lithuania it didn't really. So has the stance, the position of the IMF, changed over that period towards the currency board arrangements and don't you think it's got to be more flexibility, you know, in case when it doesn't work, it's got to be changed? And also, entering the European Union, it's inevitably that the countries will move back to the classical central banks. So don't you think that it might be reasonable to think that in some cases there was no reason to introduce these?

Mr. Keller: Let me try to give an answer. First of all, I think currency boards were introduced in some cases like Argentina, like Bulgaria, after a period of extremely high inflation to stabilize very quickly. You had a very transparent anchor to the U.S. dollar or the deutsche mark and that's certainly gave then everybody in the economy a signal what to expect. And the question is then is this something you introduce out of a difficult situation and then move away from it after some progress or do you keep that? There has been some debate. I mean basically a currency board is a fixed exchange rate and the question is do countries with fixed exchange rates do better or worse? And the answer is it depends very much.

If you look at let's say-let me take an example from a neighboring country, Germany, right. Would you believe that Bavaria would do better with a flexible exchange rate relative to the rest of Germany? I mean Bavaria has 12 million people. It's a large economy. So there is a reason to have a fixed exchange rate in certain circumstances because you have tremendous gains in efficiencies by having the same currency as the region next to you.

When I look at, for example, Estonia, which has pegged to the deutsche mark and therefore has a fixed relationship with one of its big trading markets, Finland, I'm not sure that I could see any situation where I would think that a small country that has just over 1.5 million people would gain by having its own independently floating currency because it would not be very useful except in a very limited territory.

So I think one cannot generalize the answer to that. I think that if things are not broken, why fix them? And where currency boards are very successful, I think we should keep them.
It is also clear-and the paper at the back of the room was written for a conference that I attended in Brussels about a year ago on that question-and the EU and the ECB have accepted that countries can on a case-by-case basis keep the currency board not only until EU membership, but also through ERM II. Now, what, of course, will need to be determined jointly is the central rate at which the currency will be quoted, but as President Duisenberg made it very clear in his speech in I think it was April, if a country wants to impose itself the additional discipline of not even having small fluctuation bands, then good for the country. Let them do it.

Questioner: I just wondered whether Mr. Robinson when he mentioned that we should keep some of the elements of flexibility in labor markets, what kind of aspects or elements of flexibility do you mean? How do you understand the flexibility?

Mr. Robinson: As I said, I'm not an expert on the Czech labor market, so on the specifics of Czech Republic, let me defer to Roger, but I think some of the things that we see in the European Union that you would be well advised not to have, if you don't have them already. A major problem in the European Union is that there is very little or far too little wage differentiation across skilled and unskilled workers and this is one of the reasons why there is so much regional disparity in unemployment rates as Max was mentioning. Another problem that we see in many European countries is that unemployment benefits are paid almost, well, there is no limit on the time for which they are paid, and relatively little pressure on people to actually go out and get jobs. That's also something I think you would want to avoid. But let me perhaps pass the baton on to Roger on the specifics of the Czech Republic.

Mr. Nord: In our last Article IV consultation, as well as in the last OECD report, we mentioned one issue where the Czech Republic where it needs to examine its current practices and that is in the area of the administration of social security benefits. And there is an aspect of open-endedness and of very high replacement ratios for those who draw on social benefits. I think in the reform of the social security system that the current Czech government is currently examining, this will be one aspect that needs to be looked at. In other aspects, the Czech labor market is fairly flexible, particularly compared to Central Europe. For example, in part-time work, where rigidities in some of the Western European countries have been quite harmful there, the Czech Republic is relatively flexible.

Ms. White: I'm afraid we don't have time for more questions right now, but I would before we close like to call your attention to a session tomorrow morning at nine o'clock in the Seminars Program. That session will be on "Integration Into the European Union: Challenges for Accession Countries." And there is a very interesting group of people that will be discussing that subject at nine tomorrow morning. Thank you very much for coming.


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