CATCHING UP AND THE EMU Péter Halmai Viktória Vásáry Institute of European Studies Szent István University, Hungary Economic and Monetary Union: 10 years of success? Mendel University, Brno, Czech Republic November 28, 2008

European integration Growth theory Convergence between economic development of certain countries and catch-up process of less developed countries EMU, preparation and attainment of the Euro-adoption exert significant impact on macroeconomic and institutional conditions of economic growth

Catching up Catching-up: the distance to be travelled Convergence: the measure of progress Negative/Positive catch up rate

Factors determining economic growth Supply side Labour Capital Total Factor Productivity growth accounting, production function Further factors Demand Trade and geographical situation Macroeconomic policies Institutional factors, etc.

Potential growth rate in the „old” convergence countries IrelandGreeceSpainPortugalOther countries in the Eurozone

Growth characteristics in the „old” convergence countries Significant increase in labour and capital input Impacts of labour market reforms in Spain (moderated real wages, growing employment) Remarkable TFP growth in Ireland (FDI, high- technology, intensive investment in human resource, etc.)

Potential growth and its factors 0,20,11,92,60,90,70, ,40,60,83,81,31,11, TFP 1,01,61,31,80,61,50, ,3 0,81,10,81,20, capital 0,72,00,61,90,31,60, ,31,00,41,30,10,80, labour potential growth factors 1,93,73,96,51,83,82, ,12,92,16,52,23,02, potential growth, as percentage per annum PTESELIEEU-8EU-4Eurozone

Growth characteristics in the „old” convergence countries Significant increase in labour and capital input Impacts of labour market reforms in Spain (moderated real wages, growing employment) Remarkable TFP growth in Ireland (FDI, high-technology, intensive investment in human resource, etc.) Impact of money market integration: – Decrease in risk premia, desinflation, reducing real interest rates – Decreasing capital costs – Growing gap between capital productivity and capital cost Fiscal consolidation EU-transfers - promotion of structural adaptation, 25-50% of public investments expectations, role of creditability

Development of cost of capital IrelandGreeceSpainPortugal Other countries in the Eurozone

SP/CP 1998SP/CP 1999SP/CP 2001SP/CP 2003 SP/CP 2005SP/CP 2006SP/CP 2007actual Current account deficit commitment as percentage of GDP – Portugal

Average catch-up rates in NMSs (in % per annum) -9,54-3,90-3,64SI -7,35-1,45-2,08SK -2,57-0,48-2,55PL -5,21-2,95-1,21LT -5,65-2,40-2,56LV -0,24-4,59-0,86HU -7,82-4,28-2,44EE -6,51-1,970,71CZ -3,35-1,58-1,74EU

Potential GDP growth CZEEHUPLROSKEU-15

Potential growth rate in the EU-25 The potential growth rate in the EU-25 is declining The decline is much higher in the EU-12 than in the EU- 15 in the long run Output in the EU-12 is growing faster than in the EU-15 The pace of convergence will slow down as time passes (it might stop in the long run) Significant difference between MSs (due to different productivity dynamics, demographic developments) Convergence process will continue

Potential GDP growth (annual average %) ,61,22,53,54,7EU ,31,21,42,12,2EU ,2 1,52,22,4EU - 25

Advantages of Euro adoption Additional trade Reduction in risk premium Improving conditions of FDI Disappearance of exchange rate Financial integration, development of the financial sectors Fiscal discipline Microeconomic advantages

Real and nominal convergence Productivity gap

Sources of disparities in GDP per capita compared to EU-15 (2006) -48%-39%-69%-67% Romania -39%-29%-55%-40% Estonia -35%-32%-55%-53% Poland -32%-20%-45%-29% Czech Republic -28%-25%-45%-42% Hungary -30%-22%-45%-43% Slovakia -16% -29%-21% Slovenia TFP Capital intensity Hourly labour productivity GDP per capita Source: European Commission

Real and nominal convergence Productivity gap Price level convergence (BS-effect) Structural adaptation (structure, trade, integration) Higher but more volatile growth Relatively flexible labour market Improving fiscal positions, but different fiscal soundness and quality of the public finances Significant financial integration Monetary policy transmission – structural differences

Challenges during transition Significant capital inflows – Challenge to be faced by macroeconomic and financial stability Price level convergence process – Real equilibrium appreciation through higher domestic inflation and/or nominal appreciation „Old” cohesion countries: main shock was the monetary expansion related to the euro-adoption „New” MSs: structural factor might dominate

Increasing divergence, adoption constraint Increasing diversity of the Eurozone (More volatile inflation, asymmetric shocks, etc.) Economic policy reaction to decrease related risks, at the same time to promote potential growth and structural reforms contributing to real convergence Credit booms – in the case of rapid financial integration – might result in pressure on real exchange rate Lack of of adequate adoption – economic growth is supposed to stay at a low level in the long run; the process of the real convergence might get stuck or it can even change direction Sustaining monetary stability is essential + need for structural reforms

Concluding remarks The accession to the stability oriented EMU provides remarkable long term advantages for the NMSs. The fulfillment of the nominal convergence criteria per se is not enough to ensure a robust long term economic performance. Catch-up and convergence is based on the economic growth. –NMSs – transition path – but the pace of their catch up might dwindle/stop over time (stagnating convergence club)

Long-term convergence EU-15EU-10

Concluding remarks Abovementioned assume no changes in the policies – BUT: comprehensive, integrated structural refoms could provide an opportunity to overcome the adverse developments (Lisbon type reforms)

CATCHING UP AND THE EMU Economic and Monetary Union: 10 years of success? Mendel University, Brno, Czech Republic November 28, 2008

Convergence trend ( ) GDP per capita in 1999 (Eurozone=100) Per capita GDP growth Total (except LU)