Into the EU: Policy Frameworks in Central Europe [illustrated] 1589060849, 9781589060845, 9781455216406

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lnto the EU Policy Frameworks in Central Europe

©International Monetary Fund. Not for Redistribution

l'hispage intentionally left hlank

©International Monetary Fund. Not for Redistribution

lnto the EU Policy Frameworks in Central Europe

A Staff Team Led by

Robert A. Feldman and C. Maxwell Watson,

with Peter Doyle, Costas C hristou, C hristi na Dase kin g, Dora lakova, Guorong Jiang, Louis Kuijs, Rachel van Elkan, and Nancy Wagner

International Monetary Fund Washington, D.C. 2002

©International Monetary Fund. Not for Redistribution

© 2002 International Monetary Fund

Production: !MF Graphies Section Cover design: Lai Oy Louie Typesetting: Alicia Etchebame-Bourdin

Cataloging-in-Publication Data lnto the EU: policy frameworks in Central Europe /a staff ream headed by Roben A. Fe ldman and C. Maxwell Watson; with Co stas Chrisrou... [et al.].-Washington, OC: International Monetary Fund, 2002. p. cm.

lncludes bibliographical references. ISBN 1-58906-084-9 l. European Union-Europe, Central. 2. Banks and banking­ Europe, Central. 3. Finance-Europe, Central. 4. Privatization-Eu­ rope, Central. 5. Europe, Central-Economie condirions-19916. Europe-Economie integration. 1. Feldman, Robert Alan. Il. Watson, Maxwell. III. Christou, C. (Costas). IV. International Monerary Fund.

HG! 86.C36 168 2002

Priee: US$26.00 Address orders to: International Monetary Fund, Publication Services 700 19th Street, N.W., Washington, O.C., 20431, U.S.A. Tel.: (202) 623-7430 Telefax: (202) 623-7201 E-mail: [email protected] Internet: http://www.imf.org

©International Monetary Fund. Not for Redistribution

Contents

Preface 1

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The Road to EU Accession . . . . . . . . . . . . . . . . . . . . . . . . Change in the Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Financial Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Macroeconomie Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Enlarging the EU: Accession Requirements and the Central European Candidates

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Real Convergence to EU lncome Levels: Central Europe from 1990 to the Long Term

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Sources of Growth During Transition . . . . . . . . . . . . . . . Structural Policies and Growth During Transition . . . . International Evidence on the Determinants of Long-Run Growth .. . . . . . Growth Scenarios in the Long Run . . . . . . . . . . . . . . . . .

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13

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Financial Sector Evolution: Challenges in Supporting Macroeconomie Stability and Sustainable Growth

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Financial Sector Development and Growth . . . . . 35 lnterlinkages to Macroeconomie Policy . . . . . . . . . . . . . . . . 53 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 .

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5

A Framework for Financial Stability

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The Legal, lnstitutional, and Supervisory Framework . . . . . . lntermediating Capital Flows . . . . . . . . . . . . . . . . . . . . . . . . Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Safety Nets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . International Standards and IMF Surveillance . . . . . . . . . . . . .

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76 84 88 90 91

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Contents

Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 6

Monetary and Exchange Rate Regimes

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Disinflation: Initial Success and Current Tensions .. . . . . The Run-Up to Accession: Regime Requirements and Goals in Context Considerations in Managing Flexible Regimes . . . . . . . . . Back to the Future: Wide Bands and the Rerurn to Fixity Capital Controls and Policy Safeguards . . . . . . . . . . . . . . .

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L 12 . . . 122 . . . 131 . . . 135

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Balancing Fiscal Priorities . . . . . . . . . . . . . . . . . . . . . . . . . 141

Facing che Challenges . . . . . . . . . . . . . . . . . . . . . . . . . . Medium-Term Fiscal Positions: Choosing an Appropriate Target . . . . . . . . . . . . . . . . . . . . . . . . . Revenue Reforms on the Way to EU Accession . . . . . . . Need and Scope for Expenditure Reforms . . . . . . . . . . . Reconciling Fiscal Objectives . . . . . . . . . . . . . . . . . . . . . Medium-Tenn Fiscal Management in Practice . . . . . . . . Additional Risk Facrors: Privatization Receipts and Fiscal Decentralization . . . . . . . . . . . . . . . . . . . . . . 8

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The Challenges Ahead . . . . . . . .

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150 158 162 174 175

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Text Boxes

2.1 3.1 3.2 3.3 4.1 4.2 4.3 5.1 5.2 5.3 5.4

The Acquis Communautaire . . . . . . . . . . . . . . . . . . . . . . . Estimating the Capital Stock in the CEC5 . . . . . . . . . . . Total Factor Productivity Sensitivity Analysis . . . . . . . . . Investment Ratios and Capital lntensity: ltaly 1960s; Spain 1970s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Troubles with IPB . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . The Macroeconomie Environment and Financial Sector Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Privatization Methods and Fiscal Costs of Bank Restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . EU Legislation Governing the Banking Sector . . . . . . . . European Commission's Assessment of Progress Toward Accession in the A rea of Financial Services . . . . . . . . . Impact of the Russian Crisis . . . . . . . . . . . . . . . . . . . . . . Capital lnflows into Hungary in Early 2000 . . . . . . . . . . .

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8 19 22 31 46 54 58 78 80 86 87

Contents

5.5 5.6 6.1 6.2 6.3 6.4 7.1 7.2

The Financial Sector Assessment Progra m . . . . . . . . . . . Stress-Testing of the Hungarian Banking System . . . . . . . Policies for Oisinflation . . . . . . . . . . . . . . . . . . . . . . . . . . The Maastricht Inflation Constraint and Szapary s' Boxer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Currency Boards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Many Possible Worlds of E RM2 . . . . . . . . . . . . . . . . Pre-Accession Economie Programs (PEPs ) in Future Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . Medium-Te rm Fiscal Plans of the Accession Countries Fiscal Adjustment and Growth . . . . . . . . . . . . . . . . . . . . EU Pre-Accession Assistance . . . . . . . . . . . . . . . . . . . . . Planning Spending Restraint-An Illustration for Poland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reconciling Medium- Term Fiscal Tensions: Two Cases From Recent History . . . . . . . . . . . . . . . . . . . . . . . . . . Defining Elements ofMedium-Term Fisc al Frameworks . .

7.3 7.4 7.5 7.6 7.7

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92 94 108 118 120 136 146 152 155 16 7 172 176 180

Figures

3.1 3.2 4.1 4.2 4.3 4.4 4.5 4.6 4. 7 5.1 6.1 6.2 7.1 7.2 7.3

CEC5: Sources ofGrowth, 1989-99 . . . . . . . . . . . . . . . . CEC5: Investment to GDP Ratios, 1985-1999 . . . . . . . . Broad Money (M2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real Growth of Private Credit, 1996-20 00 . . . . . . . . . . . Interest Rate Differentiai, 1995-2001 . . . . . . . . . . . . . . . Real Oeposit and Lending Rates, 1998-2 001 . . . . . . . . . Externat Liquidity Position: Selected Countries, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposit, Lending and Key-Policy Rates, 1 998-200 1 . . . . Credit to Private Sector, 1995-2000 . . . . . . . . . . . . . . . . Comparisons of Financial an d Balance of Payments Vulnerability Indicators, 1998-2000 . . . . . . . . . . . . . . Monthly Headline Inflation in the CEC5: 1991-2001 . . Monthly Core Inflation in CEC5: 1993- 2001 . . . . .. . . . Government Balances in the C EC5 and the European Union, 1993-99 . . . . . . . . . . . . . . . . . . . . . . Revenue and Expenditure Trends in the CEC5 and the European Union, 1993-99 . . . . . . . . . . . . . . . Old-Age Dependency Ratio in the CEC5 and Europe, 1990-2030 . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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16 18 41 42 44 48 68 72 73 96 102 103 149 151 164

viii

Contents

7.4 lndicators of Public Spending in the CEC5 and the European Union, 1998 0 0 0 0 0 0 0 0 0 0 0 169 7.5 Per Capita lncome and Primary Current Spending in Selected Countries, 1998 0 0 00 0 0 170 0

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l. Setting Medium-Term Fiscal Targets: The Role of Public and Extemal Debt and Current 0 0 0 . 0 0 0 0 0 0 0 191 Account Considerations II. Revenue Trends and Tax Structures 0 0 0 0 0 0 0 0 . 0 0 208 0

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Concencs

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Appendix Figures

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Externat Debt-to-GDP Ratios Ln Selected Middle-Income Countries, 1999 . . . . . . . . . . . . . . . . . A2 Saving-lnvestment Balances in the CECS, 1993-99 . . . . A3 Tax Ratios in the CECS and the European Union, 1994 and 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A4 Structure ofTax Revenue in the CECS and the European Union, 1998 . . . . . . . . . . . . . . . . . . . . . . . .

200 206 212 215

Appendix Tables

Al Fiscal Balances and Public Debt Under Alternative Scenarios . . . . . . . A2 Sovereign Ratings of Middle-lncome Coumries' . . . ...... Long-Term Foreign Currency Debt A3 Externat Current Accounr Balances and Foreign lndebtedness Under Alternative Scenarios . A4 Medium-Term Fiscal Targets Anchored on Extemal . . . Debt and Current Account Constraints AS General Government Revenue in the CECS, 1994-98 . A6 Social Contribution Rates in the CECS, Europe, and the OECD . .. . ... . .. . . ...... A7 Main Elements of the Personal lncome Tax System in the CECS and the European Union A S Corporate and Value-Added Tax Rates in the CECS and the European Union . . . . . . . . . .

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References

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The Authors .

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234

The following symbols have been used throughout this paper: to indicate that data are not available; ro indicate that the figure is zero or less than half the final digit shown, or that the item does not exist; between years or months (for example, 2000-01 or January-June) to indicate the years or months covered, including the beginning and ending years or months; between years (for example, nancial) year.

2000/01) to indicate a crop or fiscal (fi­

"Billion" means a thousand million. Minor discrepancies between constituent figures and totals are due to rounding.

The term "country," as used in this paper, does not in ail cases refer to a territorial enrity thar is a srare as understood by international law and practice; the term also covers sorne territorial entities thar are nor states, but for which srarisrical data are mainrained and provided intemationally on a separate and independent basis.

©International Monetary Fund. Not for Redistribution

Preface

This volume on the economie challenges faced by the countries of central Europe on the road co EU membership was prepared by an IMF staff team headed by Robert A. Feldman and C. Maxwell Watson. The team included Peter Doyle, who helped develop the unifying concept of the chapters, as weil as Costas Chrisrou, Christina Daseking, Dora lakova, Guorong jiang, Louis Kuijs, Rachel van Elkan, and Nancy Wagner. The material presented here also builds on research carried out by a number of other IMF staff members-including particularly Craig Beaumont, Robert Corker, Paul Masson, and the mission chiefs, desk officers, and resident representatives working on the central European economies. The chapters on monetary and exchange rate frameworks and on fis­ cal challenges draw heavily on background papers prepared for discus­ sions in the !MF Executive Board in the course of 2001-which reflected information available as of early july and mid-April, 2001, respectively. The intent of the chapters, however, has been to present material and analysis thar is of longer-term interest-both to policymakers and the public in the central European economies and to other candidates for EU membership-and they should be read with a focus on methodological and analytical issues rather than for specifie projections that are subject to change. These papers benefited from informai seminars with rhe Eu­ ropean Commission and the European Central Bank-and, in an earlier version, an academie seminar at the University of Oxford, organized by Christopher Davis of Wolfson College. The chapters on real conver­ gence and the financial sector appeared in the IMF's Working Paper series, and benefited from seminars with World Bank and IMF staff. Among the staff of the !MF and the World Bank whom the authors would particularly like ro rhank are Tam Bayoumi, Adrienne Cheasty, Michael Deppler, Dimitri Demekas, Liam Ebrill, Bernard Funck, Paul Hilbers, Peter Keller, Russell Kincaid, Tim Lane, jimmy McHugh, Roger Nord, Kyle Peters, Marc Quintyn, Roberto Rocha, Susan Schadler, jerry Schiff, and Dimitri Tzanninis. The views expressed, however, are the sole xi ©International Monetary Fund. Not for Redistribution

xii

Preface

responsibility of the authors, as are any remaining errors. The prepara­ tion of this book benefited greatly from the editorial advice of Jeremy Clift, from assistance provided by Indra Perera and Joy Rivera in prepar­ ing the text, and from the research assistance of Amber Hasan and David Maxwell. The focus of this work on the five central European economies-the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia­ complements earlier cross-country studies prepared by IMF staff on the transition economies. l n no way should it be understood to represent a view of the staff about the relative readiness of particular candidate countries to accede to the European Union. Washington, March 2002

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1

The Road to EU Accession Robert A Feldman and C. Maxwell Watson

For the countries of central Europe-the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia-this is the Accession decade. By contrast with the uncharted waters of transition in the 1990s, the approaches to European Union (EU) membership-and beyond thar the euro-are, in many respects, mapped out in advance. And the prospect of EU membership, from the early days of transition, has served as a policy anchor, helping to catalyze and sustain coalitions for reform. But policymakers face continuing challenges as they frame macroeco­ nomie and financial sector policies during the run-up to accession and, in due course, monetary union. These challenges are the subject of the studies presented here. A leitmotiv in these chapters is that monetary and fiscal policies cao­ not be veneered onto the real economy. They need to be infonned by an understanding of the changes underway in both real and financial mar­ kets, and must be in tune with the specifies in each country. There will, no question, be a family resemblance among successful cases. This was already a hallmark of the transition years, when the leading countries all moved quickly t0 impose hard budget consrraints on enterprises and, more generally, to underpin macroeconomie stability with deep structural forms. But in terms of specifics-across the range of economie policies-one size will not fit all.

Change in the Economy Several underlying trends in their economies-in both the real sector and in the financial market setting-will indeed require skillful policy management, t0 ensure that growth is bath strong and sustainable.

©International Monetary Fund. Not for Redistribution

2

The Road

ro

EU Accession

Notably, the economie setting is likely uncertainties:

to

be marked by significant

•

As living standards continue to converge toward cutTent EU levels, investment ratios may weil rise further. The likely magnitude of this shift should not be exaggerated. Ouring the transition decade it was probably productivity performance thar most distinguished successful cases, not the sheer volume of new investmenr. But as in­ vestment increases, a key issue is whether domestic saving will rise in tandem, or whether widening current account deficits could compromise the prospects for sustained growth.

•

Productivity growth itself entails challenges, from a macroeco­ nomie policy perspective. The pace of such growth in tradables may be accompanied by appreciation of the real exchange rate (the Balassa-Samuelson effecr). Again, it is far from clear thar this effect will be very sizable. But-as real exchange rates appre­ ciate-it will likely cause sorne tension bet\.veen low consumer priee inflation and any desire to keep the nominal exchange rate broadly stable, both of which are requirements for adopting the euro and participating fulty in Economie and Monetary Union.

•

Major policy-driven changes also are still underway in the real sec­ tors of the central European economies-enterprise and bank re­ form, in sorne cases, and in others rhe streamlining of mines or the modernization of agriculture. Moreover, there are massive invest­ ment needs, including for infrastructure, and important challenges in addressing the legacy of poor environmental policies. These changes entai! sizable fiscal cosrs-rhough to cali them cosrs of the acquis communautaire 1 is rather misleading: the vast majority of changes are the prerequisites of growth or the fees of good global citizenship. But of course there are also specifie expenditures asso­ ciared directly with joining the European Union rhat will only partly be offset by EU transfers.

•

And, finaL!y, policymakers must seize the opportunities and negoti­ ate the shoals of an ever-changing financial market setting-one characterized by sizable, and potentially variable, capital flows. This, too, will test macroeconomie policy skills and resolve.

1For a detailed description of the

acquis communautaire see Box 2.1

in the ncxt chapter.

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The Financial Sector

3

So this is the setting in which macroeconomie policy needs to steer a very careful course. Not only does fiscal policy have to absorb significant direct costs: it must also contain any excessive pressures on the externat current account. Monetary policy-with fiscal policy in support-must keep inflation in check, while grappling with the vicissitudes of capital inflows and occasional turbulence or contagion.

The Financial Sector For monetary and fiscal policy to be able to do their jobs, the lesson of experience so far in these five central European countries, as elsewhere, is that a well-functioning financial sector is absolutely critical. Sound banks can help buttress corporate governance-and elimi­ nate the budgetary threat from lingering quasi-fiscal deficits in the enterprise sector. Healthy financial institutions, with good risk man­ agement, can !essen the risk that capital inflows may be driven by im­ plicit guarantees or entai! mismatched borrowing-or, more generally, be intermediated in ways thar can foster instability. A strong financial sector can support the development of private sector businesses and less advanced regions, avoiding the emergence of a dual economy-and minimizing calls for official guaranrees or subsidies rhat will add to fis­ cal deficits. And this sector has a key role in the efficient transmission of monetary policy. ln short, the financial sector is at the crossroads of the macroecon­ omy-with considerable potential to invigorate growth or impair eco­ nomie stability. To bring out the best in this sector, a weil thought out approach to strengthening its underpinnings-in areas such as super­ vision and regulation, creditor rights, and accounting standards-is essential. Ensuring thar banks, and the financial sector generally, support­ not hinder-economic potential has been of particular relevance to the !MF, and the World Bank, in working with the authorities of the central European members. Most of these countries have been among the first to take part in the joint !MF-World Bank Financial Sector Assessment Program (FSAP). These FSAP reviews have found the countries moving quite swiftly to adopt standards such as the Basel core principles of supervision, and in severa! cases having put behind them most of the banking problems that stemmed from the soft budget constraints and the "quasi-fiscal deficits" of the central planning era.

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4

The Road to EU Accession

Macroeconomie Policies The challenge for macroeconomie policymakers is how to guide expec­ tations and foster stability in a setting of quite rapid real change and fi­ nancial market uncertainty. This question lies behind the discussion of real secror developments and financial market trends, motivates the em­ phasis on strengthening financial sector underpinnings, and is a central focus of the last two chapters-on monetary and fiscal policy frame­ works. Ir is a setting that calls for transparent and well-defined policy regimes tailored to the circumstances of each country. Monetary frameworks must be transparent and credible, if they are to steer expectations effectively. With none of the central European coun­ tries opting for a currency board, they have typically been migrating to­ ward the other end of the spectrum-more flexible exchange regimes, which minimize the risk of speculative attacks and discourage unhedged borrowing. The role of the exchange rate in these regimes is not such that it powerfully guides expectations. In practice, inflation targeting has proved a popular anchor-indeed, in a modified form, it may remain rel­ evant under ERM2 (the transition regime toward adoption of the euro thar involves an exchange rate band with margins of± 15 percent around a declared central rate versus the euro). But how low should these countries' medium-term inflation targets be? There are sound economie arguments to keep inflation weil clown in the single digits. But with real exchange rate appreciation underway, and major shifts in relative priees to accommodate, it may not be sensible to aim too quickly for consumer priee inflation rates as low as below 2 percent. Even under flexible regimes the exchange rare is a critical variable in these very open economies, and it is too important to be neglected. Adjustments in the monetary-fiscal policy mix may be called for to mod­ erate wide swings in the exchange rate-a consideration thar will be­ come critical once, with adoption of the euro in view, countries move to adopt an ERM2-style regime. And if monetary policy is to be successfully geared ro containing inflation, then support from fiscal policy will be needed-for example, to avoid too strong an appreciation of the ex­ change rate. ln this among ether ways, fiscal po licy will be at the fulcrum in managing the stresses of pre-accession. For fiscal frameworks the overarching goal must be ro foster growth thar is strong-but also sustainable. ln the central European economies, this means assuring adequate investment, and reducing tax rates (no­ tably on labor). But crucially, it also means thar fiscal policy will need

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Macroeconomie Policies

5

to address risks of financial vulnerability by keeping externat eurrent ac­ count deficits within prudent bounds. A case-by-case assessment (pre­ sented in the last chapter of this book and its appendices) suggests thar, for considerations of this kind, medium-term fiscal positions in these economies may weil need, depending on the country, to be kept to a rea­ sonably small deficit or near balance-but for reasons of fundamentals, not because of a concem to meet Maastricht or Stability and Growth Pact goals prematurely. This underscores the potential tension for the managers of budgets in the central European economies. To safeguard growth-oriented expen­ ditures and key reform outlays, ether spending categories will have to adjust-including the bulk of primary current spending programs that can be restructured and reduced without impairing medium-term growth prospects. While specifies differ, steps to improve efficiency ryp­ ically include restructuring the ci vil service and social security sys­ tems-including through improved targeting of social transfers, as their levels are typically high for these economies' incarne levels. Tax bases, too, can be broadened and tax administration improved as high social security contribution rates are eut. Bearing in mind a setting of macro­ economie and financial uncertainty, the implementation of tax cuts will however, need to be phased in prudently to avoid an injudiciously sharp widening of the fiscal deficit. ln an environment that is uncertain, and with a need for important structural reforms of public spending, the framework of fiscal policy is par­ ticularly important-and the scale of the challenge should prompt, not discourage, a strong medium-term orientation to policy. By establishing links with macroeconomie goals, this can expose tensions early-and set policy on a strategie course so that, for example, ad hoc cuts in investment can be avoided at times of budgetary stress. Over rime, medium-term fis­ cal frameworks can also help build credibiliry and the pre-accession eco­ nomie programs that these countries are submitting to the EU are pro­ viding valuable reinforcement of this strategie approach. Medium-term expenditure frameworks, in particular, deserve to be more fully developed-arriculating key reforms upfront, and specifying how positive or adverse changes in the economie environment will be handled. These are approaches to fiscal policy thar can provide an anchor for policy and a vehicle to establish credibility: !essons from the experi­ ence of EU members are noted. In this context, there is clearly need for an iterative approach to medium-tenn fiscal frameworks-taking macro­ economie considerations as a starting point, and establishing trade-offs

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6

The Road ro EU Accession

between new priority programs, public sector restructuring, and prudent consolidation goals. An approach along these !ines can also provide a quantitative framework within which to assess realistic timetables and funding for the implementation of the acquis communautaire. *

*

*

*

*

In sum, the path to EU accession is manageable-albeit challenging. Ten years ago, the central European countries met one of the most daunt­ ing challenges of economie history, the transition from central planning, with little certainty as to policy approaches or economie outcomes. While their current situations differ, huge strides have been made in transforming their economies, furnishing experience to guide the com­ pletion of reforms, and strengthening institutional structures. The expe­ rience of other emerging market economies, too, offers comparative guid­ ance. And, most important!y, the experience over time of the present EU members-who faced sorne major challenges on this same course-offers a pivotai guarantee: for the economies of central Europe, with the right policies, the full benefits of EU membership-including, in due course, participation in the eurozone-are clearly within reach.

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2

Enlarging the EU: Accession Requirements and the Central European Candidates Robert A Feldman and C. Maxwell Watson

The principle of an EU enlargement toward central and eastern Europe was first announced at the European Council meeting of Copenhagen in June 1993. This committed the European Union to admitting coumries that had signed association agreements with it. 2 A Iso of considerable sig­ nificance, the European Council established the so-called Copenhagen criteria for EU accession. These criteria represented an understanding that central and eastern European countries would be admitted to the European Union once they had met certain conditions. This criteria established a number of benchmarks for assessing their progress toward economie and political compatibility with the EU. The Copenhagen criteria comprise the following elements: ( i ) the existence of stable institutions ensuring democratie govern­ ment, the rule of law, human rights, and the protection of mi­ norities (often referred to as the political criteria); (ii) the existence of a functioning market economy and the capacity to cope with competitive pressure and market forces within the Union; and, (iii) the ability to take on the obligations of membership, including ad­ herence to the aims of political, economie, and monetary union. zouring the first half of the 1990s, the European Community and its Member States progressively con cluded Association Agreemenrs or so-called Europe Agreements wirh ren counrries of central and eastern Europe. These Europe Agreements provided the legal basis for bilateral relations be tween these countries and the EU. Temprano-Arroyo and Feldman ( 1999) provide a summary of the ins titutional rel arions berween the EU and these coumries (including the five cenrral European countries in this srudy) iollowing the fali of the Berlin Wall and le ading up ro accession negotiarions.

7 ©International Monetary Fund. Not for Redistribution

8

Enlarging the EU

Box 2. 1 . The Acquis Communautaire

The acquis communautaire is the body of EU legislation, pracrices, principles, and objectives accepted by the member states. lt includes: intra-EU Treaties-mosr importandy the Treaties of Rome, the Single European Act, and the Maastricht and Amsterdam Treaties; l egislation enacted at the EU level and judgmems of the European Court of justice; principles in the areas of justice and Home Affairs; Foreign and Security Policy; and Treaties of the EU wid1 third countries. The acquis has accumulated over many years and amounrs to over 12,000 legislative acts. For the purpose of the accession negociations, rhe European Commission (EC) has divided up the acquis into 31 "chapters."1 On each chaprer, the acces­ sion candidates negotiate with the EC on the required legislative and pol icy changes. One side or the other may seek a temporary exemption from the acquis

for a "transition period"-for example, a moratorium on the purchase of land by foreigners (requested by sorne applicants) or a delay in the free movement of labor (requested by some EU members). The CEC5 have ail opened 29 chapters and,

as

of November 28, 2001, had pro visionally closed between 1 9 (Poland)

and 23 (Hungary) chapters. The closing of a chapter does not necessarily imply 1Free movemems of goods, freedom of movement for persans, freedom to provide ser­ vices, free movemenr of capital, company

law, competition policy, agriculture, fisheries,

transport policy, taxation, economie and monetary union, srarisrics, social policy and em· ployment, energy, industrial policy, small and medium-sized undert�kings, science and re· search, education and training, telecommunications and information technologies, culwre

and audiovisual policy, regional policy and coordination of structural instruments, envi­ ronment, consumer health protection, cooperation in the fields of justice and home affairs,

customs union, external relations, common foreign securiry policy, financial control, fi­ nancial and budgetary provisions, institutions, and other issues.

The last entails the adoption, implementation, and enforcement of the body of EU law and institutional provisions-the acquis communau­ taire. This includes, as described in Box 2.1, the need to adopt the EU's instirutional and legal provisions in the area of Economie and Monerary Union (EMU). The Copenhagen Council noted, as a further condition, the EU's capacity to absorb new members without slowing the pace of European integration. A number of EU financial assistance instruments have made available funds to support the accession process.3 3Candidate countries need to provide cofinancing, of about 25 perccnr , for most of the projects financed by the pre-accession funds; and they nwst have in place the necessary administrative infrastruc ture.

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Accession Requiremencs

9

thar the EC considers the reform agenda in the relevant policy area complete. Ir means thar the timetable for its adoption is accepred. Indeed, in its Regular Re­ ports, the EC increasingly stresses the need

co

raise candidates' administrative

capacity to implement and enforce the acquis. The chapters dealing with "the four freedoms"-movement of goods, move­ ment of persons, provision of services, and movemenr of capital-have a scrong bearing on the macroeconomie framework. Parts of the first and fourth freedoms, dealing with uade liberalizarion and capital movements, were already dealt with in the Europe Agreements signed in the fi.rst half of the 1 990s. However, they are still subject to negotiation, including, as mentioned above, possible transition pe· riods. The chapters on "transport policies" and "environment" imply significanr fiscal outlays. The chapter on "taxation" calls for the alignment of severa! indi· reet tax and excise rates. Chapters such as "consumer and health protection" imply minimum requirements on social policy (equal conditions, labor law, health and safety at work). Many other -chapters also imply a need to adopt EU standards. The chapter on Economie and Monetary Union calls for tfuee distinct phases for monetary and exchange rare policy: (i) the pre-accession phase; (ii) the ac­ cession phase, covering the period from the date of accession to adoption of the single currency; and, (iii) the final phase of the adoption of the euro. During the pre-accession phase, candidate counrries adopt and implemenr the required EMU-related legislation to become a Member State with a derogation from the adoption of the euro: completion of the orderly liberalization of capital move­ ments; prohibition of any direct public secror financing by the central bank and of privileged access of the public sector ro financial institutions; and alignmenr of the national central bank statures with the Treaty, including the indepen­ dence of the monetary authorities.

In its most recent Regular Reports, the European Commission con­ cluded thar eight of the ten transition country candidates are funcrion­ ing market economies, and ali five of the central European economies discussed here were in this group.4 While there are substantial economie differences among the five, they should be able, according to the Reports, to cope with competitive pressure and market forces within the Union in the near term, provided they continue with, and in sorne cases reinforce, 4November 2001. The orher rhree functioning marker economies were deemed robe Esronia, Latvia, and Lirhuania. Since 1998, the European Commission has prcparcd annual Regular Reports rhat describe the progress of individual accession candidates in meeting the Copenhagen criteria and in rransposing rhe EU's acquis.

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10

Enlarging the EU

a number of differing measures. As concluded by the Goteborg European Council in 2000, "provided thar progress towards meeting the accession criteria continues at an unabated pace, the road map should make ir pos­ sible to complete the accession negociations by the end of 2002 for those candidate countries that are ready. The objective is thar they should par­ ticipare in the European Parliamenr elections in June 2004 as members."5 While the candidate counrries of central Europe are among the more advanced transition economies, they are also a diverse group. F or exam­ ple, per capita incomes (based on purchasing-power-parity valuation of country GDPs in 2000) ranged from €8,700 in Poland ro € 1 6, 1 00 in Slovenia, compared with an EU-15 average of €22,500. Their degree of openness to trade cliffers (measured in terms of the sum of exporrs and imports, from about 60 percent ofGDP in Poland t0 140 percent ofGDP in Slovakia). And the scope and depth of structural reforms undertaken have varied markedly over rime within the group. The path from central planning to mature market-based economies on a broad basis started only a decade ago (a little earlier in some coun­ tries), so the transformation of these economies over such a shorr perind has been both radical and impressive. The private sector's share of GDP has increased ro 60 percent or more. Two-thirds of rhese countries' ex­ ports are sold in EU markets, and the EU provides two-thirds of rheir for­ eign direct investment inflows. Moreover, it is remarkable how far and how quickly the countries moved to liberalize foreign trade. Most devel­ oping-or even industrial-countries rook severa! decades to achieve what these countries did in a few years. On the macroeconomie front, considerable progress has also been achieved, with inflation now firmly in the single digits, clown-in some cases-from triple-digit levels. But what ali five of the central European countries also have in common­ beside the prospect of EU membership-is that they still have some way togo in, for example, reforming their public sectors, building up rheir in­ stitutional and administrative capacities, improving infrastructure, and protecting the environment.

5The accession treaty will be subject to approval on the EU's side by the COlmcil and by the European Parliament, taking account of the final Opini(ln which the Commission will submit on the outcome of the negoriations. TI1e Treaty resulting from the accession negotiations will then be formally signed by the parties concerned (Membcr States and candidate countries) and submitted for ratification by the contracting States in accor­ dance with their respective constitutional requiremenrs. Given the ti me needed to C\1111plete this process, new members could join by early 2004.

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Accession Requirements

ll

l n past enlargements of the European Union, there were fewer acced­ ing countries than are likely ta be included in the next wave of enlarge­ ment.6 ln the expansion of 1973, the Union took on three countries (Denmark, lreland, and the United Kingdom) ; one in 1981 (Greece); two in 1986 (Spain and Portugal) ; and three in 1995 (Austria, Finland, and Sweden). Thus, even accession by the five countries of central Europe would already imply a larger increase in the number of countries than any of the previous expansions. While the impact on population and incarne would be much smaller than during the southern enlargement of the 1980s, these five countries would nevertheless expand the Union by 66 million, or almost 18 percent of the population of the current members of the EU (the EU-1 5 ) , and the increase in GDP (based on the purchasing­ power-parity valuation of country GDPs) would be 8 percenr. The in­ crease in land area would be about 550 thousand km2, or about 17 percent of the EU-15. Enlargement will have wide-ranging implications for the European Union. These include political, institutional, and social implications, in addition to significant budgetary and other economie ramifications. De­ pending on the transition periods, and on future reforms ta EU policies, the enlargement can be expected to imply increased costs for the EU bud­ get, since most of the transition countries are comparatively poor, popu­ lous, and agrarian. The addition of further members will inevitably com­ plicate the decision-making process within the EU, and extending qualified majority voting, already a subject of ongoing discussion among current members, may be one way to ensure efficient decision making. The European Central Bank (ECB) governing council, which decides on euro­ area monetary policy, has 18 members at present (the governors of the area's 1 2 national central banks, in addition to the ECB's 6 executive board members). Adoption of the european single currency-an eventual post­ accession requirement for the enlargement countries----could expand the size of the council or prompt modifications in the way it operates. 6The Helsinki European Council in 1999 clarified in precise œnns which countries would be eligible for candidate status and agreed thar negotiations would be starœd with ali candidates thar met the Copenhagen political criteria. Accession negociations with the Czech Republic, Poland, Hungary, Slovenia, and Estonia began in March 1998; with Bulgaria, Larvia, Lirhuania, Romania, and the Slovak Republic in February 2000. The EU has said thar every candidate country would be judged on its own merirs, so thar countries thar starœd negociations larer would have a chance to catch up wirh rhose thar started earlier-as has been rhe case, for example, with the Slovak Republic-opening rhe door porenrially to simulraneous accession by a large group.

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Enlarging the EU

12

Member states have general!y welcomed the prospect of a furrher en­ largement of the EU and see many positive benefits from it. As noœd by the European Commission, "Since the invitation to the candidate coun­ tries to become part of the European Union, the enlargement process has contributed decisively to achieving political srability, economie progress and social justice [in the candidate countries]. Stable institutions, changes of governmenr on the basis of free and democratie elections, re­ inforced protection of human rights, including righrs of minorities, and market economy principles are now common features. The enlargemcnr process makes Europe a safer place for its citizens and comributes ro con­ flict prevention and control in the wider world."7 Moreover, the Com­ mission views accession as able ro further enhance economie perfor­ mance, not only in the candidate countries but also in the present member states.8 To realize most fully this potential, ir is important for the candidate countries ta design appropriate macroeconomie policy frameworks on the road t0 EU accession and the lacer adoption of the euro. The ovcr­ arching goal of such frameworks has to be to support real convergence to EU levels of income-doing so by fostering growrh thar is not only srrong but also sustainable. In this conrext, the subsequent chapters rurn in sequence to the process of real convergence thar is underway in rhese economies; the relevance of change in the financial secror for macro­ economie policy and performance (and vice-versa); the design of mone­ tary and exchange rate regimes; and the management of 1nedium-rerm fiscal challenges.

7See "Sua regy Paper 200 l ," http://europa.eu.inr/comm/cnlarg�menr/r�pcmlt\' 1/mdt!.dwn.

p. l.

8See "The Economie Impact of Enlargement," by the Oin.:..:rm>1rc G�no.:r.11 1,,r Ecnnnmic

ami Financial Affairs, Enlargement Papers Numhcr 4, June :!001, a,·,lilablc at

ro(>a.eu. int/comm/economyJrnance/(mblicarions/enklrgemencpapers_en.hrm

hrt(l:l/w­

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3

Real Convergence to EU lncome Levels: Central Europe from 1 990 to the Long Term Peter Doyle, Guorong Jiang, and Louis Kuiis

For transition cnuntries in the process of joining the EU, the prospects for the real secror will be critical in determining the appropriate policy frameworks both before and after accession. This chapter discusses the key factors likely to shape the nature and pace of growth in five of rhese countries in central and eastern Europe thar form the focus of this book: Poland, the Czech Republic, the Slovak Republic, Hungary, and Slove­ nia-known collectively as the CECS. The discussion is based on the standard growth accounting frame­ work thar decomposes growth into the growth of factor inputs and a residual-total factor productivity (TFP) growth.9 The chapter reviews the growth performance of the CECS during the 1990s, noring thar the available evidence points to a significant diversity-with the most: rapidly growing countries exhibiting growth thar is intensive in TFP rather than in factor inputs, while the less successful countries exhibit the reverse tcndencies over this period. l t also notes evidence of differ­ entiai producrivity growrh in the rradable vis-à-vis the nontradable secrors and the implications for the real exchange rate. The prospects for growth in the CECS are then discussed in relation to the patterns of growth in Europe from the 1950s onwards and of east 9Thc growrh accounting framework urilizes the following idcntity: dY/Y = c:ulK/K + [3dL/L + dA/A,

where the production function cakes the form of Y = AK«L�. and Cl. and � are rhe elasric­ iry of ourpur with respect ro capital and labor. ln practice, Cl. and � are 8Slovakia's FSAP was cheduled s for the 2002 fiscal year.

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A Framework for Financial Stability

92

Box 5.5 The Financial Sectar Assessment Program ln May 1999, rhe !MF and the World Bank joimly launched the Financial Sector Assessment Program (FSAP).1 The main output on the IMF's side

s i the

Financial System Stability Assessmenr (FSSA) thar is discussed by the IMF's Executive Board in rhe conrext of a counrry's Article IV Consultation. This box describes the key elements of this program.

Objectives •

Wirh crisis prevention the key aim, the FSAP exercise focuses on the soundness and stabiliry of the financial system as a whole. The FSAP offers an assessment of factors thar cou Id make rhe system vulnerable to instabil­ ity and suggests measures ro reduce such vulnerabilities, including develop­ mental priorities.

•

The FSAP is intended to highlight the linkages in both directions between

•

The FSAP involves an assessmenr of observance and implementation

financial system developments and macroeconomie outcomes. of relevant standards, codes, and good practices applying to the financial secror. •

The FSAP serves as a basis for assisting the participating country in de­ signing an operational sequencing of financial sector reforms.

Scope The typical scope of an FSAP mission includes: the macroeconomie environ­ ment; financial institutions' structure; financial markets; risk management pro­ cedures; the legal and regularory framework and the system of supervision, in­ cluding observance of standards, core principles, and good practices; the institutional and legal arrangements for crisis managemenr; and key refom1s to minimize sysremic risks and reduce vulnerabilities. The FSAP undertakes an assessment of financial secror vulnerabilities. The building blocks of this include macroprudential analysis, srress tests of the bank­ ing system, and an assessmenr ofcounrries' observance of the inremational stan­ dards relevant

t0

the financial sector. These include standards in the areas of

banking supervision, payments systems, insurance, securities, and monetary and financial policy rransparency. Summaries of these assessmenrs of adherence to international standards can also be published as various module(s) of Reports on the Observance of Standards and Codes (ROSCs). The ROSC reports have typ­ ically comprised two elemems-a description of country practice and an inde­ pendent commentary by IMF staff on the extent to which these practices are consistent with the relevant standard.

1 Furrher details on the FSAP can be found on rhe LMF's websire or in Hilbers (2001 ).

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lntemarional Srandards and /MF Swwillance

93

standards. These include the Core Princip/es for Effectitte Banking Supen>i­ of the Base[ Committee on Banking Supervision, the Objectives and Princip/es of Securities Regulation of the International Organization of Se­ curities Commissions (IOSCO), the lAIS Insurance Supervisory Princi­ ples, the Core Principles for Syscemically lmportam Payment S)'Stems, and the Code ofGood Practices on Transparency in Monetary and Financial Poli­ cies. As confirmed by the outcomes of the FSAP exercises, each of the four participant countries in the CECS has made considerable progress with respect to these standards, but a few remaining weaknesses were also highlighted (sorne of which were discussed above). The CECS partici­ pants have voluntarily chosen to publish the Financial S)'Stem Stabi!it)' As­ sessments (FSSA)59 and Reports on the Observance of Standards and Codes (ROSCs) related to the financial sector. This rransparency increases the accountability of policy makers and should improve the environment for market participants' investment decisions, ultimately leading m im­ proved policymaking and economie performance. In addition ro assessing compliance with international standards, the FSAP takes a broad look at a wide range of factors which could affect fi­ nancial stability and vulnerability, with a focus on the linkages between financial system developments and the macroeconomy. An FSAP, for ex­ ample, typically includes a series of stress tests, conducted under a vari­ ety of macroeconomie scenarios and externat shocks, in orcier ro assess the banking system's vulnerability to market and credit risks. lndeed, the stress tests for the parricipating CECS countries indicated that their banking systems could likely weather most externat or domestic shocks. Nevertheless, an FSAP-and stress tests in particular-can only exam­ ine vulnerability at a point in time and should not, therefore, be con­ strued as a "bill of health." For this reason, one of the most important as­ pects of an FSAP is to encourage the authorities ro continue with such monitoring on its own. lndeed, the National Bank of Hungary (NBH) subsequently launched an excellent and comprehensive semi-annual Re­ port on Financial Stability, and the second issue featured the NBH's own stress test, modeled after thar performed during the FSAP (Box 5.6). Macroprudential analysis-moniroring financial vulnerabilities on the basis of objective measures of financial system soundness-has also becn employed in the context of these FSAPs. lndicatOrs for such analyses can include macroeconomie variables associated with financial system vulnersion

'9"fhc exception was Hungary. As a pilor panicipant in the FSAP, ir was unahle tn pub­ lish its FSSA.

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94

A Framework for Financial Stabi lity

Box 5.6 Stress·Testing of the Hungarian Banking System Hungary was one of 12 participants in the pilot project of the Financial Sector Assessment Program (FSAP). An integral aspect of this assessmenr was a quan­ titative analysis-stress tests under various scenarios-on commercial banks'

balance sheets to determine the extent of possible systemic vulnerabilities. Since the FSAP, the National Bank of Hungary (NBH) has begun to conduct its own stress tests along the lines of chose used in the FSAP. This box provides an overview of the stress tests described in the NBH's February 2001 issue of the

Report on Financial Stabiliry.

Monte Carlo techniques were used to examine the exposure of the Hungar

­

ian banking system to market risk (including domestic interest rate, foreign cur­ rency, and foreign interest rate risks) and credit risk. Examination of the balance sheets (with banks grouped into six categories by size and profitability) indicated thar inrerest-bearing assets were concentrated at short maturities, and longer

loan conrracts were generally written with interest rates chat adjusted fre­ quently, thereby minimizing repricing risk. The portfolios also indicated a low leve[ of exposure co foreign currency risk. As a result, stress-testing scenarios (both uncorrelated and correlated), using interese rate and exchange rate shocks (based on the largest such changes over specified historie periods ranging from

5 to lO years) indicated thar the overall impact of market risk on the banking system overall was quite modest-with a combined impact in the wost r case sce­ nario equivalent to about 7V2 percent ofTier 1 capitaL

The impact of credit risk was much greater, where credit risk was examined under rwo scenarios: ( l ) a shift in the portfolio composition roward loans from government securities, and (2) a deterioration in the loan portfolio measured by a two-standard deviation increase in nonperfonning loans. The model relies exclu­ sively on macroeconomie variables and handles both market and credit risks in an integrated framework. While the first scenario indicated an impact of about 5\tl 1 capital the second cenario s suggested chat, for the banking sys­

percent of Tter

,

a whole, the additional provisioning requirement could be as great as 42 percent ofTier 1 capitaL Although credit risk is, therefore, a significantly greater source of risk chan market risk, the stress-testing results suggest thar neither source of risk would Likely compromise the capital soundness of the banking system. tem as

ability (for example, current account deficit, composition and maturity of capital flows, exchange rate volatility, foreign exchange reserve adequacy, etc.), aggregated microprudential indicators of the health of financial in­ stitutions (for example, the CAMELS framework)60 and market-based in-

60CAMELS encompasses information on Capital adequacy, Asset quality, Management

soundness, Earnings/profitabiliry, Liquidity, and Sensitivi[y to marker ri

k.

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Conclusions

95

dicators (for example, credit ratings and sovereign yield spreads). Figure 5.1 on the next page illustrates, for the CECS, sorne of the macroeconomie indicators used to assess financial and balance of payments vulnerability. ln addition to the FSAP exercise, the IMF's regular surveillance also attempts t0 carefully monitor financial sector vulnerabilities, with an in­ creased emphasis in the aftermath of the emerging market crises of rhe 1990s. As the IMF builds up experience in the broader framework of vul­ nerability assessments (including macroprudential analysis, early warn­ ing systems, and analyses of reserve adequacy and debt sustainability), ir has encouraged country authorities to assist in this effort by compiling and publicly disseminating macroprudential information. lndeed, the CECS have been among the early subscribers to the IMF's Special Data Dissemination Standards (although macroprudential indicators are not specifically part of the SDDS). including, notably, the detailed remplace on international reserves and foreign currency liquidity.

Conclusions The CECS countries have made remarkable progress in reshaping their financial sectors: the challenge is to build on this by deepening the legal framework and institutions thar underpin financial stability-transpar­ ent accounting and auditing, comprehensive supervision, effective bank­ ruptcy mechanisms, and adequate collateral registration and recovery mechanisms. More specifically, in addition to completing restructuring and privatization, the remaining agenda includes: •

enhancing the legislative framework and working toward effective implementation, including, in particular, streamlining the proce­ dures for collateral liquidation;

•

strengthening the independence of supervisory authorities and their legal powers;

•

implementing effective consolidated supervision, which should forestall any trend to spin off riskier activiries to affiliated nonbanks subjecr to less regulation;

•

developing supervisory skills relating to cross-border operations of banks-an especially important rask in the inregrated market;

•

enhancing the laws and supervision abilities to meer the needs of a more sophisticated market place-including Internet trading and derivatives;

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96

A Framcwork for Financial Srabiliry

Figure 5. 1 . Comparisons of Financial and Balance of Payments Vulnerability lndicators, 1998-2000 Average current account deficit (Percent of GDP}

Short-term debt to reserves1 (Percent of reserves)

-7

����--��� Republic

Average export volume growth, 1 997-2000

Broad money to reserves

(Percent}

(Percent of reserves}

Czech Hungory Polond

Republic

� .-------�

Slovok Slovenia Republic

Official reserves in months of imports of goods and services

Czech Hungory Polond Slovok Slovenio

Republic

Republic

REER appreciation, annual average2 1 998:1 -2000: 1 2

8 .------.

Czech Hungory Polond Slovak Slovenia

Republic

Republic

Czech Hungory Poland Slovak Slovenio Republic Republic

Sources: IMF, World Economie Outlook; ond IMF staff estimates.

1 Debt falling due within one year. 2CPI based REER.

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Conc/w;ions

97

•

improving risk management practices, especially in the area of mar­ ket risk management-but also with respect to credit, operational, and systemic risk;

•

bringing accounting practices, such as asset valuation, in line wirh international practice: balance sheets should reflect market values as closely as possible; and

•

ensuring that a financial safety net (such as deposit insurance or lender-of-last resort facilities) is in place, but is limited so as not to engender moral hazard.

With restructuring and privatization virtually finished in some cases, and weil under way in others, completing the remaining agenda for financial sector reform would help ensure that the CECS approach EU accession with financial systems able to withstand most shocks. Key ele­ ments in this progress have been the effort to harmonize legislation with that of the EU, advances in implementing international financial stan­ dards, and participation in recent IMF-World Bank initiatives, such as the FSAP and publication of the associated ROSCs. These efforts should Lay the basis for more effective monetary transmission, help parry capital account hazards, and avoid future threats to fiscal sustainability. By ensuring a stable financial environment, they are a critical foundarion to allow the CECS to close their economie gap with the economies of the European Union.

©International Monetary Fund. Not for Redistribution

6

Monetary and Exchange Rate Regimes Rachel van Elkan, Robert A Feldman, Louis Kuijs, and C. Maxwell Watson

The policy challenges confronting monetary authorities in central Europe over the next few years-as they design and modify their mone­ tary and exchange rate regimes-are in many respects similar to those facing other emerging market economies.61 The cemral challenge is to complete and consolidate disinflation, and secure financial stability, against the backdrop of major structural changes in the real economy and sizable-possibly volatile-international capital flows. But the CECS are undertaking, in addition, a specifie policy agenda: the reforms required for EU and, ultimately, euro area membership. Policymakers, therefore, must also be attentive t0 developing monetary, exchange rate, and financial frameworks thar are consistent with these goals. While the choice of appropriate monetary and exchange rate regimes can contribuee crucially to assuring low inflation and real convergence in a stable setting, success will also depend to a high degree on supporting policies. ln a setting marked by sizable capital Lnflows, support from fis­ cal and financial sector policies, in particular, will be key. Realistically, however, monetary aurhorities must reckon thar this support could prove variable over time. Fiscal policy, for example, will face serious stresses as real convergence continues and as countries, with the aid of substantial EU support, mobilize their own resources in parallel to implement the acquis communautaire and modernize their economies. And domestic

61This chapter builds on Corker and ethers (2000) in light of cominuing experience in the cemral European coumries, and elaboraœs cerrain themes in more decail-including notably medium-rerm goals for inflarion, the implications of capital inflows, operational aspects ofmore flexible exchange rare regimes, and capital comrols and policy safeguards.

98

©International Monetary Fund. Not for Redistribution

Moneta1y and Excllange Rate Regimes

99

financial systems, even where deeply restructured, are still maturing-a process fraught with hazards. A broad range of policies will need to be properly coordinated, and over a sustained period-a difficult task, but one thar is essential to pany the undeniable risks surrounding the con­ vergence process. Among other things, these elements introduce more than the usual degree of uncertainty over the impact of monetary policy on the economy. ln this setting, four questions are likely to be at the core of monetary authorities' concerns. First, what monetary and exchange rate regimes­ and what specifie anchors for policy-offer the best prospects of deliver­ ing dis inflation securely, wh ile mitigating risks of financial instability and supporting growth? Second, in a setting of real convergence, what is a re­ alistic target for inflation over the medium term-bearing in mind the impact of relative priee adjustments still underway? Third, what are the preconditions for moving to a wide exchange rate band and declaring a fixed central rate against the euro-such as an ERM2-like band?62 And fourth, how rapidly should remaining capital controls be removed, and what policy safeguards are needed in this regard? To shed light on these admittedly complex questions, this chapter seeks to draw on recent experience in other emerging markets, and to blend this with considerations specifie ro the late stages of transition and the EU accession process. lt suggests a number of priorities for policy: •

Given the likelihood of continuing real appreciation, due to Balassa-Samuelson effects and other relative priee changes, there is a plausible case for aiming over the medium term for CPI inflation in low single digits-but not necessarily as low as 1 to 2 percent per annum. Such a strategy poses a potential dilemma, clown the line, in relation to the Maastricht requirement of sustaining low infla­ tion-though not necessarily to a degree that is insuperable in prag­ matic terms when the rime cornes.

•

To get co that point, ir will be important to progress further on priee liberalization. The share of regulated priees in the CPls of the can­ didate countries is much higher than of the euro area countries and, in sorne cases, priees are regulated below cost recovery levels.

6ZERM2 is rhe transition regime roward adopring rhe euro. lrs key fea[Ures include an exchange rare band with margins of± 1 5 percent around a declared cenrral rare againsr the euro.

©International Monetary Fund. Not for Redistribution

100

Monerary and Exchange Rare Regimes

•

Well-functioning labor markets, in addition to a prudent macroeco­ nomie policy stance, are key ingredients to supporting and/or main­ taining the disinflation process-a substantial challenge requiring sustained policy resolve.

•

While exchange rate pegs were useful in the early stages of disinfla­ tion, the balance of advantage in central Europe has tipped roward more flexible regimes-in particular to avoid providing an ex­ change rate "guarantee" to domestic borrowers or offering too easy a target for speculative attack.63 Nonetheless, even under flexible regimes, the exchange rate will remain too important to be ne­ glected, and adjustments in the policy mix may be called for to moderate wide swings in the rate-a consideration rhat will become critical once, with major structural transformations completed and the adoption of the euro in view, countries move to participate in ERM2.

•

Where policymakers opt for flexibility in the form of a free float or a wide band over the next few years, a specifie nominal anchor will be called for to guide inflation expectations. Any hard band wide enough to discourage speculation will likely prove too wide to guide inflation expectations forcefully. One obvious candidate as an anchor is inflation targeting (freely, or subject to a wide-band con­ straint). The use of sorne "soft" exchange rate target-for example, an undeclared inner band-should not be ruled out as the focus of short-term monetary policy operating procedures, but a declared band poses financial market hazards, while an undeclared band alone lacks the virtue of transparency.

•

As they move from "emerging" to "converging" status, these coun­ tries may be ar least as vulnerable to financial crises as earlier EU and EMU candidates. High quality observance of international standards and codes can help parry crises-as could use of the IMF's Contingent Credit Unes. In addition, removal of residual capital controls needs to be prudently phased with the attainmenr of sus­ tainable and suitably flexible macroeconomie policies and, crucially, the completion of financial reforms that reduce the balance sheet

63An alternative would lie in a very hard peg, but none of the central European economies has adopred a currency board, and the circumstances that might (avor that ap­ proach now lie largely in the past.

©International Monetary Fund. Not for Redistribution

Disinf/arion: Jnirial Success and Ctmem Tensions

101

risks and hence the prospect and costs of a crisis. The existing lati­ tude for EU members to reimpose controls temporarily in a crisis (with the approval of the Council of Ministers) will, of course, re­ main available, including in the period before mutual commitments with the European Central Bank are in place to support exchange rate commitments under ERM2.

Disinflation: Initial Success and Current Tensions A majority of the central European economies began transition with high-in some cases very high-rates of inflation. This reflected rapid priee liberalization, the unwinding of overvalued exchange rates, and the realization of pent-up demand associated, in sorne cases, with the elimi­ nation of monetary overhangs. Typically, monetary authorities adopted exchange rate pegs to anchor expectations; fiscal reforms were pursued vigorously, while the development of government debt markets reduced pressure for the monetization of deficits;64 and in most cases incomes pol­ icy or tripartite understandings played a supporting role, which, among other things, compensated to some degree for remaining soft budget con­ straints in the enterprise sector. By the end of 1994, year-on-year CPl inflation in all these economies stood at moderate levels-in a range of about 10 to 30 percent; and, de­ spire some setbacks, there has been no tendency for serious inflationary pressures to reemerge (Figures 6.1 and 6.2). This was the case even though fiscal or quasi-fiscal pressures continued to put pressure on resources in some countries. This success in taming inflation, and avoid­ ing a serious relapse, is a testimony to the strong commitment of mone­ tary authorities. l t also reflected a choice of exchange regimes thar matched quite weil the evolving circumstances of each country (Corker and others, 2000). As a preliminary to discussing future options, it is helpful to examine this recent degree of fit between regimes and country circumsrances. lni­ tially, as small open economies addressing major risks of inflation (and 64A broader developmenr affecring monetary policy implementation for the central banks concerned has been the shift from direct to indirect monerary instruments. Al­ rhough nor always easy in renns of the uncertainries abour the monerary transmission channels thar came with it, such a shifr has been general!y successful and necessary in lighr of the need to create incenrives for competition in financial markets (and help prepare for future EU/EMU membership).

©International Monetary Fund. Not for Redistribution

1994

1 995

1 999

©International Monetary Fund. Not for Redistribution

1998

2000

2001

L_ __ __ �------�--�--_J_______L� 1997

__ __ __

L_

1 996

--

-L------�----

----

1 993

�

----

1992

�

---

Sources: Dolo pmvided by national atllhoio- ties; and IMF slolf eslimates.

1 991

O L-

10

20

30

40

50

60

70

80 .-------,

(PeTcenf, year-Ofl-year}

Figure 6. 1 . Monthly Headline Inflation in CECS: 1 99 1 -2001:

199.d

1 995

Hu�

... - - - -· '�

1 996

,

1 997

,

'··-··

...._ ..____

.. ... . .... . . . .

- -.

---

1 998

1 999

©International Monetary Fund. Not for Redistribution

Sourœs.: Oola provided by national authorities; and IMF s1all' estimates. 1 Net inBotion exdudes regulaled pcices end the impoct el indired la>< changes. 'core inllotion i� cokulaled by removing seosonol foods, nonregufeted fuels, molor fuels, and phormoceulicol goods From lhe CPI. 3Net ïnllotion exdudes lood end fuels. "core inllotion excludes regulaled fl"Îces end !he impoct of indired 1axes. SSeries exoludes food end erergy. Estimotes ore prepored by !he lnsti!ule for Mocroeconomic Analysis and Development, Sktvenia.

5

.

•.

2000

200 1

------ ----------JO r--� -----------------------------.

Figure 6.2. Monthly Core Inflation in CECS: 1 993-2001 (Percenf, year-on-year)

0

104

Monetary and Exchange Rate Regimes

Table 6. 1 . Exchange Rate and Monetary Policy Regimes in the CECS Country

Exchonge Regime

Official Intervention

Capital Controis

Monetory Goal

Czech Republic

Relotively free Aoot

CXcosionol intervention to smooth lorge swings in the exchonge rote.

Lorgely liberolized

Announced torgets for heodline inAction: declining from 3-5 percent in Jonuory 2002 to 2-4 percent in December 2005.

Hungory

Wide bond of +!- 1 5 percent, with central pority to the euro

No intervention so for

Recently liberolized

An onnounced target for heodline inRotion of 4.5 percent at end·2002 and 3.5 percent at end·2003, with o ± 1 percent tolerance bond.

Polond

Free Aoot

No intervention

Slovok Republic

Relotively free floot

long·term controis liberolized. Some controls on short·lerm capital Aows.

CXcosionol intervention lo smooth lorge swings in the exchonge rote.

Lorgely liberolized

Announced inflation benchmorks: for end· 2002, heodline inAction of 3.5-4.9 percent and core inAction of 3.2-4.7 percent; for end· 2003, 4 percent for core inAction.

Slovenio

Monoged Aoot

Lorgely Exchonge rote is liberolized dosely monoged to contoin liquidity (by limiting interest rote differentiel with EU) and ovoid excessive volotility in the exchonge rote.

Announced medium· lerm target for heodline inAction: 3-4 percent in 2005; interim forecosts: 5.8 percent end·2002; 4. 1 percent end· 2003.

Announced torgets for heodline inAotion: 5 percent at end· 2002; below 4 per· cent ot end·2003.

with newly refonned institutions), a majority of them found ir advanra­ geous to peg the value of their currencies to thar of a much larger, low in­ flation, country in order to import credibility and fix the inflation rate of traded goods. (Slovenia was an exception in this regard.) Crucially,

©International Monetary Fund. Not for Redistribution

Disinflation: Initial Success and Current Tensions

105

goods and factor markets were relatively flexible, allowing pegs to put more onus on adjustment of wages and priees. This was especially im­ portant given the need to absorb major structural upheavals in the real economy: ongoing reforms-notably in the enterprise and financial sec­ tors-created an independent source of potential shocks to supply and demand, as weil as complications for fiscal policy. Over the past few years, however, pegs gave way ro more flexible regimes-and countries' speed of movement in this direction maps plausibly to differences in economie characteristics (Tables 6 .1 and 6.2). Poland's relatively early move to exchange rate flexibility was in keeping with its relatively large size (its population is equivalent tO about 10 percent of that of the EU, alrhough its total GDP is less than 2 percent of chat in the EU), lower degree of openness (trade volume relative to GDP is less than half of that in the other CEC5 ), and its greater restructuring needs in key sectors. The need ro address restruc­ turing, eliminate remaining quasi-fiscal pressures, and improve the functioning of tabor and product markets supported the maves to flex­ ible exchange rate policy in the Czech and Slovak Republics and in Slovenia. Hungary's lengrhy perseverance with a narrow band regime was relatively weil supported by a particularly flexible labor market, a healthy financial system, and the advanced stage of enterprise reform. However, cross country differences in these metrics should not be ex­ aggerated, and at a broader levet, ail five countries share similarities: a high degree of openness, rapidly growing commonality of their trade and output structures with those in rhe EU and, for the most part, suf­ ficient labor market flexibility to justify some degree of alignment of their exchange rates to the euro. The specifie course of each country is summarized in Box 6. 1-and from this experience three areas emerge in whieh monetary policy has encountered tensions. ln addition to cyclical factors, key issues have been the degree of support from fiscal policy in comaining externat current account pressures, and the constraints of chosen exchange rate regimes, taking intO accoum extemal capital flows: •

Relative cyclieal positions appear to have been associated to a grow­ ing degree with recent divergences in inflation performance. In Hungary and Slovenia, where inflation in 2000 picked up ro near 10 percent, the increase tended to coïncide with a srrengthening in aggregate demand. The increase in demand likely reduced the gap between potential and actual output, creating conditions in which a pass-through of exogenous priee pressures to the general priee

©International Monetary Fund. Not for Redistribution

106

Monetary and Exchange Rate Regimes

Table 6.2. Exchange Rate Regimes and Basic Economie Characteristics of the CECS Czech Rep.

Hungary

Poland

Slovakia

Slovenia

EU

Exchange Rate Regime and Monetary Policy Frameworks

Exchange regime1

Managed Wide band lndependent Managed floot floot Aoot

Monetary policy frameworks

Real GDP growth, 1 996-2000 average CPI inAction (2000, average)

Inflation target

Inflation target

1.0

4.1

4.0

9.7

lnRation target

Managed Aoot

lnRatian lndicators benchmark of liquidity and other economie variables, divided into Iwo pillars

5.2

4.1

4.3

2.2

10.1

1 2.0

10.8

1.2

17

Si:z:e and Openness2 Per capita GDP

(percent of EU-15) at current exchange rates ot PPP exchange rates Population (percent of EU) GDP (percent of EU) Shore of total extra-EU trade3 lmports and exports (percent of GDP)4 Exports to EU (percent of total) lmports from EU (percent of total)

24

21

18

1 00

49

39

46

43

60

68

100

2.7

2.7

10.3

1 .4

0.5

100

0.7

0.6

1.9

0.2

0.2

100

2.2

2.2

3.1

0.8

0.8

134

112

60

141

121

64

73

68

56

66

63

64

66

50

69

4.5 Agriculture lndustry & construction 41 .8 Services 53 .7 Agricultural employment as shore total 5.5 Trade strvcture-deviation from EU5 27 Exports 16 lmports

5.9 32.7 6 1 .4

4.8 36.5 58.7

4.6 33.3 62.1

3.9 37.7 58.4

30.7 67.0

7.5

19.1

8.2

1 1 .5

5.2

14

52

36

21

11

13

73

Alignment with the Euro Area2 Shores of GDP (percent)

35 15

©International Monetary Fund. Not for Redistribution

2.3

32 19

Disinflation: Initial Success and Currem Tensions

107

Table 6.2 (concluclecl) Cze

thar even against a common background of transition, recommended medium-term fiscal balances are not identical. This reflects many factors, including different starting positions, different economie prospects (for example, for the behavior of sav ing investment balances), and also dif­ ferences in definitions-which hamper comparisons across countries. ln view of the usual host of uncertainties on the macroeconomie front, and also because of measurement problems which should !essen as data quality improves over rime-projections will undoubtedly be revised moving forward. Fiscal balance targets may need to be reconsidered as a resulr. Ir is also fair to say that the debate between the IMF and country authorities has not focused exclusively on issues of deficit size. lt has fo­ cused deeply on the need to eliminate quasi fiscal deficits and to move forward with public expenditure reforms-and rhus to reorient the pub­ Lic finances in support of growrh, raking into account the potential tensions between fiscal adjustment, on the one hand, and growth­ supporting revenue and expenditure reforms on the other. Revenue and expenditure reforms are the subject of the next two sections. -

-

-

Revenue Reforms on the Way to EU Accession A reduction in the tax burden on labor income should be a priority in aU five countries. When social security contribution rates are combined with persona! income taxes, the nominal tax wedge exceeds 40 percent of gross salaries in ail five countries, and reaches about 60 percent in Hungary and the Slovak Republic.112 These tax wedges on labor are high even by the standards of existing EU members-where the average nominal tax wedge is below 40 percent. Reducing the wedge between gross and net salaries should boost both labor demand and incentives to work, thus fostering higher growth and a lasting reduction in unemployment rates. 1 1 1

1 12The magnitude of the tax wedge has important implications for employment and our­ put, as large tax wedges increase tabor costs and rhus rcduce the offered wage and/or the demand for tabor. Take-home pay is tower and workers therefore substitute toward teisure or home production, reducing tabor supply. High taxation on tabor income can also re­ duce formai employment and encourage gray market activity, with negative consequences on tax revenue. 1 11In theory, though probably unlikely in practice, the increase in the base can dominare the effect of the rate eut, with the result of rising overall rax revenues. TI1is is generally re­ ferred ro as the "Laffer-curve effect," and is associated with high rates ar the our.ser.

©International Monetary Fund. Not for Redistribution

A key challenge for the five accession candidates is ro ensure rhat a reduction in the tax rates on tabor income is well coordinated and se­ quenced with a broadening of tax bases and improved tax administra­ tion, to avoid excessive revenue losses.114 The authorities could broaden tax bases if they eliminated various tax credits, reduced exemptions, and srrengthened tax administration so as ro improve collection rates. The revenue effect of tower tax rates on tabor could be offset, at !east in part, by higher employment and a shift of activity from the gray economy to the forma[ sector. Moving doser to principles applied in more advanced economies coutd help address weaknesses in tax administration. The effectiveness of tax administration differs across the five countries. Oepending on the cir­ cumstances, there may be scope to improve the managemenr and orga­ nization of tax offices and to enhance coordination berween tax collec­ tion agencies. The focus should be on grearer specialization in the functions of the staff in tax offices to support a system baseJ on self-as­ sessment (for example, processing returns, collecting tax arrears, and car­ rying out audits). l n addition, headquarrers operations may requirc strengthening so thar tax departments are better equipped to implement criticat reform measures. The maintenance of consistent data on raxpay­ ers, and a regular exchange of information berween revenue agencies are also important elements of an effective administration. Efficiency gains obtained rhrough specialization would free resources from routine under­ takings and could be redirecred roward audit and enforcement activiries. To this end, improvements in staff training and introduction of modem systems (including a unique rax identification number) would be crucial. Finally, given the high levet of rax arrears in some countries, tax admin­ istration reforms need to include strengrhening collection enforcement procedures, granting the necessary legal powers ro the tax administration t0 combat tax evasion, and reforming the framework of penalties and fines in order to discourage noncompliance. Efforts to conform with EU 114These efforts would build on past successes in modera ting tax dist,)ruons and luw.-r­ ing rares. Appendix I l providcs a brief ovcrview of revenue trends and t...

��

r.

3:::

Balancing Fiscal Priorities

184

distinguish policy commitments from projections and avoid a loss of credibility in the case of simple projection errors. Again, a higher leve[ of uncertainty, which raises the likelihood and magnitude of projection errors, gives this feature more importance. •

Policy commitment is typically expressed in tenus of expenditure ceilings. This permits the operation of automatic stabilizers in both directions on the revenue side, while securing the consolidation ef­ fort on the spending side.

Coverage should ideally extend to all levels of general government.

However, commitments, in terms of spending ceilings, may have to be

limited to central govemment expenditures, depending on the degree of autonomy of local govemments (see below). Cyclical spending compo­ nents are sometimes excluded, to permit expenditure stabilizers to oper­ ate in both directions and avoid slippage in noncyclical outlays in times of economie upturns. Similarly, particularly uncertain and volatile spending items could be excluded from the ceilings to avoid having to compensate for their unexpected movements by ad hoc adjusnuents in ether expenditures. The risk, however, is thar excluded expenditures may undermine the medium-tenu objectives. A possible alternative may be to combine tight subceilings for managed expenditures with some upper bound for overall spending. Approaches to inflation differ greatly. Real planning provides greater resource certainty, as inflation shocks are accommodated. The use of spe­ cifie deflators for different spending categories, however, is problematic as it discourages desired adjustments to relative priee changes. These !essons, translated to the specifie circumstances of the accession candidates, suggest four basic recommendations for implementing formai medium-tenu fiscal frameworks. First, given the wide range of uncertainties in the externat environ­ ment and the cost implications of reforms, medium-term frameworks should be formulated on a rolling basis (that is, updated every year ro in­ elude an additional year of projections), in arder to permit adjustments to shocks. The time horizon should be sufficient to signal pressures ahead, and indeed, a five-year period will be mandatory under the PEPs-though the firmness of the political commitment would be stronger in the earlier years and influenced by the election cycle. The medium-term framework should be complemented by longer-tenn projections for demographically sensitive revenue and expenditure items (such as pensions) to indicate potential refonn needs early on.

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Addirional Risk Faccors

185

Second, medium-term fiscal objectives should be based on conserva­ rive macroeconomie projections and prudent assumptions about private sector behavior. As argued above, this rule is justified by the ease of im­ plementing subsequent tax cuts, in the case of fiscal overperformance, relative to the political difficulty of introducing additional spending re­ straint (or undesirable tax increases) when fiscal deficit targets are in danger to be exceeded. Sorne bias in favor of fiscal overperformance is also consistent with the general objective of reducing deficits. However, mechanisms will be needed to help determine how policy should respond when faced with fiscal overperformance, taking into accoum cyclical conditions and exremal pressures, at the rime. Third, medium-term fiscal frameworks should specify the govern­ ment's strategy for tax reforms, but maintain (and clearly state) some flexibility. This includes both allowing stabilizers to operare and main­ taining discretion about the precise phasing in of envisaged tax cuts. The latter provides a safety margin to protect priority spending (on infra­ structure, for example) in the event of negative surprises. Fourth, finn political commitments should be made in terms of ceilings for managed expenditure, covering the bulk of primat)' current spending that is targeted for adjustment over the medium term. Setting the ceilings is an iterative process thar reconciles deficit and revenue objectives with quantified spending needs in priority areas and projections of spending on uncertain transition- and accession-related items. Critically, the ceilings must catalyze agreements on reform measures to achieve them, and finn political cornmitments, by increasing the stake of meeting the ceilings, help ensure thar they are realistic and credible. Nonethelcss, preservation of fiscal objectives may cali for subsequent adjustments in managed spend­ ing-possible in a rolling framework--or a reconsideration of Ù1e ether components of the medium-term plan, such as the timing of tax cuts or of certain transition- and accession-related spending, if warranted.

Additional Risk Factors: Privatization Receipts and Fiscal Decentralization While privatization inflows-still expected to be sizable in the Czech and Slovak Republics and Poland-can be instrumental in reducing the pub­ lic debt and future interest payments, they also risk weakening the fiscal reform momentum, if spent unwisely. Projections of average annual in­ flows over the period 2001-05 range from fairly small amoums (in percent

©International Monetary Fund. Not for Redistribution

186

Balancing Fiscal Priorities

of GDP) in Hungary (where privatization is mostly complete) and Slove­ nia, to 1 percent of GDP in Poland, and sorne 2Yz percent of GDP in the Czech and Slovak Republics, but both the magnitude and timing are highly uncertain. In addition, all countries are expected to generate re­ ceipts from the sale of mobile phone (UMTS) licenses. While these in­ flows, if used to retire public debt, can help offset part of the cost of re­ forms by lowering future interest expenditures,139 they also entai! risks: specifically, vast additional receipts are likely to generate pressures for higher spending or, at !east, weaken public support for expenditure re­ straint. Thus, privatization receipts and other "windfall gains" (such as the ones associated with the sale of mobile phone licenses) mighc weil resulc in higher medium-term deficits (excluding these receipts) in the absence of a clear and credible agreement to repay public debt. By reducing future interest payments, a debt-reduction strategy would spread the benefits of privatization over a longer period, without weakening the reform mo­ mentum. The freed resources could then be used to advance reforms, tax cuts, or the envisaged deficit reduction. An additional and more lasting complication for the achievement of medium-term fiscal objectives stems from the devolution offiscal authority to local govemments. ln three of the five accession candidates, namely, the Czech Republic, Hungary, and Poland, local govemment activity accounts for at !east one-fifth of overall govemment spending. Decentralization, while partly a historical country-specifie phenomenon and partly driven by the accession process ( with the need for regional levels of govemment to qualify for EU cohesion funds) , also reflects deliberate decisions of govem­ ments to allow greater responsiveness of spending decisions to the prefer­ ences of citizens in different constituencies.140 On the other hand, a large fragmentation of fiscal authority poses problems of its own. Thus, it is im­ portant to put in place mechanisms to ensure budgetary discipline.141 ll9Retiring public debt could also foster market confidence and have a favorable signal­ ing effect by reducing risk premia and thus leading ro lower future borrowing cosrs.

140Efficiency gains from fiscal decentralization are associated with the benefic (or sub­

sidiarity) principle, suggesting that a given service should be provided by the level of gov­ emment thar most closely represents the region benefiting from such service. For an in· deprh discussion of issues of fiscal federalism, see Ter-Minassian (1997), and Dunn and Werzel (2000 ) for a focus on transition economies. 141To improve budgetary discipline, fiscal ROSC (Reports on the Observance ofStandards and Codes) modules-based on the lMF's "Code ofGood Practices on Fiscal Transparency" available on the JMF's website http://www.imf.org/-are a useful instrument. These modules, usually prepared by the !MF in collaboration with country authorities, describe fiscal opera­ tions, reporting and their legislative basis, and identify areas for possible improvement.

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Additional Risk Factors

187

A possible prudent approach would suggest maintaining fairly tight budget constraints on local govemments while allowing sufficient room for spending decisions within these constraints. This could be achieved by assigning sorne limited taxing powers to local govemments; linking earmarked transfers from the central govemment to objective criteria; and setting effective limits on local government borrowing subject t0 their payment capacity. Besicles striking an appropriate balance between control and accountability, the main challenge is to ensure that the mechanisms supporting fiscal discipline do not undermine other objec­ tives-including the provision of sufficient resources to deliver the de­ sired leve! and quality of public services; and the maintenance of broad equity across regions and municipalities. Reforms to strengthen the effi­ ciency of local governments are warranted and likely to requirc lat·ger ef­ fective autonomy at the subnational leve! over time, both in terms of generating own revenues and gaining greater access to financial markets. This will cali for mechanisms to enhance fiscal coordination, create ad­ ditional incentives for local governments to pursue policies consistent with overall medium-term objectives, and improve the local govcrn­ ment's management capacity. The latter will be particularly challenging in light of EU accession, as many EU-related public investmcnts will have to be carried out at the subnational level. These additional considerations will need to be factored in whcn designing fiscal frameworks. This complicates the process, not !east be­ cause of the effort required to get commitments upfront. But by making these commitments, the likelihood of fiscal policy success is significantly increased.

©International Monetary Fund. Not for Redistribution

8

The Challenges Ahead Robert A. Feldman and C. Maxwell Watson

As the countries of central Europe move through the final stages of the accession process, policymakers need to brace for what may be an array of political and economie challenges. Among these are the challenges thar face ali emerging market economies in a world of strong and poten­ tially volatile capital flows. These flows can yield the benefit of acceler­ ated growth and convergence toward the income leve! of the more ad­ vanced economies. But tapping their full economie porential requires important disciplines in macroeconomie and financial policies. The goal of EU-and ultimately euro-area-membership adds two important dimensions to these challenges: the crucial advantage of an economie and political anchor; and the specifie priorities involved in adapting policy frameworks to mesh with those of the European Union. Earlier chaprers of this book sought to trace the implications of this goal for financial sector, monetary, and fiscal policies-drawing on the experience of earlier accessants to the European Union, but also of emerging market economies elsewhere in the world. A number of leit­ motivs ran through the analysis in these chapters, and norably thar: •

policies need to foster growth thar is not only strong but sustainable, avoiding the real and financial sector setbacks thar caused "lost decades" in sorne other regions;

•

policies must be robust enough to anchor-indeed harness-expec­ tations, yet be flexible enough to adapt to shocks, whether their source is domestic or extemal;

•

policy frameworks, to achieve this, need t0 be transparent and to build credibility, so chat the response of economie agents will lever­ age the impact of policy actions;

188 Not for Redistribution ©International Monetary Fund.

The Challenges Ahead

189

• there is no cookie-cutter approach: policies need to be firmly rooted

in the specifies of real and financial market changes in each coun­ try, as well as domestic political priorities. . . • . . . but there is likely to be a family resemblance among successful

solutions, with key features including firm macroeconomie policies and strong institution building. For severa! reasons, a strong and intelligently crafted fiscal policy is likely to prove a critical component in this process. Through a growth­ oriented composition of expenditure, well-designed taxes, and the avoid­ ance of excessive deficits, it can lay the foundations for both private sec­ tor growth and macroeconomie stability. It is a critical complement and support for effective monecary and financial sector frameworks. But these policy priorities must, unquescionably, be understood in a broader political setting. For the people of central Europe, accession to the European Union is far from a technical affair, or even a question nar­

rowly focused on fostering higher average living standards. le represents

a set of political and economie choices to opt intO the European Union as a key dimension of cheir ever-increasing participation in the global economy. Sorne aspects of this process are basic but profound: the deep embed­ ding of democratie structures, or the added layers of political and eco­ nomie security. Sorne, of course, enta il choices chat are difficult, and not just in the short run: to open up to the foreign ownership of land, for example, or co set limits-upper and lower-to the extent of stace in­ volvement in running the economy. Seen from the European Union side, too, this endeavor has many challenges. Clearly, political and economie security, and the opportu­ nities inherent in a wider European space, still have the power to com­ mand attention and support. But there are also some-probably exag­ gerated-concems about inward labor mobility. And there are more pervasive worries (again, likely not really warranted) about the impact of enlargement on wage levels or dispersion. There are deeper institu­ tional issues too. For the European Union's institutions-from the Council to the Central Bank and the Budget-enlargement can be ex­ pected to prompt adaptations. Accession and enlargement, cwo sides of che institutional coin, de­ pend for their success on the breadth and wisdom of popular and polit­ ica! vision. Too narrow and technical a view has the potential to trig­ ger a negative dynamic on both sides-and in the opinion poils there

©International Monetary Fund. Not for Redistribution

190

The Challenges Ahead

are at times troubling straws in the wind in this regard. Managing the political process with imagination is the essential prerequisite for suc­ cessful integration on borh sides of the present EU border. Ir requires that the longer-run goals for Europe sustain, through thick and thin, the vision of aU participants. That broader political perspective, of course, lies well beyond the reach of this book. Economie issues nonetheless, are deeply relevant ro it. A strong and uninrerrupred rise in living standards is crucial; and so wo­

in the accession countries as weil as present EU members-is sustained job creation for aU groups of skills. The message for policymakers in the central European economies s i clear: to help ensure thar the fruits of growth are fully realized and are spread widely across regions and society. These are elements that will play a telling role in the overall political equation. And, in achieving these goals, well-designed financial, mone­ tary and fiscal frameworks in the countries of central Europe will play a critical role.

©International Monetary Fund. Not for Redistribution

Appendix 1 SeHing Medium-Term Fiscal Targets: The Role of Public and External Debt and Current Account Considerations

This Appendix illustrates how public and external debt and current account objectives can be translated into medium-rerm fiscal targets, applied to the five accession countries. The analysis is undertaken within a simple quantitative framework, in which the medium-term fis­ cal position is linked to public and external debt objectives-either di­ rectly or via the current account. The main rationale for this link is the desire to limit external vulnerabilities and lower the risks of crises. As a country's vulnerabiliry to crisis depends on many factors beyond the mere size of debt ratios and current account deficits, however, externat objectives may well differ across the five accession candidates. 1 A com­ prehensive country-specifie assessment of externat vulnerabiliry goes beyond the scope of this Appendix lnstead, the exercise below applies a rather mechanical method, as a first pass at informing the setting of country-specifie objectives. The focus on applying a consistent methodology to ail five countries comes at the expense of a more considered country-specifie assessment. Thus, the conclusions can be interpreted as reference points for a more nuanced assessment in individual country studies. .

1Such factors include, among other things, the exchange rate system, the sources of rhe current account deficit, the nature and maturity profile of capital inflows and debr swcks, and the soundness of the financial sector. For a discussion of these and orher factors con­ tributing to currency crises, see Berg and orhers (1999).

191 ©International Monetary Fund. Not for Redistribution

192

Appendix 1

Public Debt Dynamics Decisions about the appropriate fiscal position over the medium term are often linked to the concept of public debt sustainability. The analysis of public debt sustainability typically determines the primary fiscal balance in percent of GDP (PB) that is required to achieve a stable debt-to-GDP ratio (0).2 lt is given by the following relationship: PB = (r - g)D/(1

+

g) - A,

where r denotes the real interest rate; g the real GDP growth rate; and A nondebt financing (for example, privatization receipts) in percent of GOP. The above condirion is expressed in rerms of gross debr, alrhough net debt can be a better measure of sustainability (to the extent that financial assets can be liquidated quickly to reduce gross liabilities). The choice here reflects the dominant focus on gross debt (as, for example, in the Maastricht criterion) , and the results are identical, in terms of the primary balance, if it is assumed that assets remain constant as a share of GDP.3 l t is obvious thar a country's fiscal stance cannot indefinitely defy the notion of public debt sustainability, as growing indebtedness would eventually lead to a vicious circle of rising risk premia on interest rates, mounting fiscal deficits, and a suppression of economie growth. How­ ever, it is conceivable that countries with a low public debt burden at the outset can afford deviations from the above rule for sorne time, particu­ larly if the borrowed resources are used to finance public expenditures that improve the long-run growth potential of the economy. Neverthe­ less, a rising trend in the debt ratio may be difficult to reverse, and pro-

2Jr should be noœd thar the condition of a nonincreasing debt ratio is not idenrical with the rheorerical notion offiscal susrainability, derived on rhe basis of the government's pre­ sem value budget consrrainr (PVBC). An analysis of the larrer rypically answers the ques­ tion whether current (or alrernative) policies can be susŒined over the long run. This is nm rhe question addressed here, as countries are assumed ro target a long-term balance or surplus. ln any evenr, the above condition is often used as a substi[Ure for the PVBC (see, for example, Blanchard, 1990), due ro its appeal in terms of intuition and simpliciry. lrs principal weakness-which is further discussed below-is irs arbitrariness. For a discussion of alternative approaches to assessing fiscal susrainability, see Chalk and Hemming (2000). 3Buiter ( 1985) analyzes fiscal sustainability on the basis of net debt (or net worth) as a share of GDP, but the gross debt concept, used by Blanchard (1990), finds a wider appli­ cation, reflecring the general difficulry of obŒining accurare information on the rrue size of governmem net worth (see Chalk and Hemming, 2000) .

©International Monetary Fund. Not for Redistribution

Appendix 1

19.3

jected (or existing) ratios may be considered too high and costly in terms of their impact on credit ratings and risk premia. On the basis of explicit governmenr liabilities, current fiscal plans do not trigger disturbing debt dynamics over the medium tenn. First, the out­ standing (explicit) public debt-to-GDP ratios are not very high in most of the countries, ranging from 1 5 percent of GDP in the Czech Republic and some 25 percent in the Slovak Republic and Slovenia to some 45 percent in Poland and 60 percent in Hungary.4 Second, with average real GDP growth anticipated in the range of 4-5 percent over the medium term, and current projections of privatization revenues, public debt ratios are likely to decline-or, in the case of the Czech Republic, not to increase substan­ tially-provided major fiscal slippage is avoided. Table A l illustrates these results, by determining the primary (and implicit overall) fiscal balances consistent with stable public debt ratios. Under the (arbitrary) assumption of a real interest rate of 5 percent, stable public debt ratios would be con­ sistent with average fiscal deficits ranging from about 2 percent of GDP in Slovenia to more than 6 percent of GDP in Hungary-reflecting mainly its higher initial debt level and primary surplus. 5 Such deficits would in all cases, but the Czech Republic, imply some fiscal deterioration relative to the 1999 deficit ourcome. ln other words, reductions in the deficits-as planned-would be associated with falling public debt ratios in these countries. And even in the Czech Republic, where the debt ratio is likely to rise, this is not an overriding concern at the moment either, given the law initial debt leve!. However, measures to reverse the adverse trend will need to be put in place before debr ratios reach conceming levels. The above conclusions still hold, in essence, iJ implicit debt is taken into account. Such debt exists primarily in the Czech and Slovak Republics in terms of state-guaranteed loans t0 enterprises and nonper­ forming loans of state-owned banks.6 ln the Czech Republic, total govern­ ment guarantees amounted to 14 percent of GDP at end-1999, and the cost of bank restructuring-while highly unccrtain-could amount to 1 5 percent of GDP. If these potential liabilities were included in full, to pro4The figures are actual ratios of nominal general governmem dehr, as a share of GDP. in 1999, consistent with the definitions u�ed in !MF staff repom and the Wlorld Economie Otulook.

;If inrerest rares were 1 percentage poinr higher, the fiscal positions would han� w be tighter by 0.1 percentage points oi GDP in rhe Czech Republic (wirh the lowesr initial debr ratio) and 0.6 percenrage points in Hung

:g "'

Appendix Il

215

Figure A4. Structure of Tax Revenue in the CECS and the European Union, 1998 (Percent)

Contributions of individuol taxes to total tox revenue 120 .-------� 100

80 60 H==--l 40 20 O Czech Republic

• Personollncome Tox • Property Tox

D Soôoi Secvrity Tox D Taxes on Goods

0 Corporole lncome Tox • Other Taxes

Tox revenue os o shore of GDP 45 r-------�

40 35 30 25 20 15 10 5

o lll-� Czech Republ ic

Hungory

Sources: OECD, Revenue Stotistics, ( 1999); vorious Recent Economie Developmenls Reports; and IMF staff estimotes.

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216

Appendix II

Table A6. Social Contribution Rates in the CESS, Europe, and the OECD (Percent of gross labor income)

Ernployer's Contribution

Employees'

Contribution

Total

35.0 9.0 3.3 19.5 3.2

12.5 4.5 6.5 0.4

47.5 13.5 4.4 26.0 3.6

36.0 1 1 .0 3.0

1 2.5 3.0 8.0 1.5

48.5 14.0 30.0 4.5

16.7-24.4 0.0 6.5 9.8 0.4-8.1

18.7 2.5 6.5 9.8 0.0

35.4-43.1 2.5 13.0 19.5 0.4-8. 1

Slovak Republic Heolth Sickness Pen sions Unemployment

38.0 1 0.0 3.4 21.6 3.0

12.0 3.7 1.4 5.9 1.0

50.0

Slavenia Heolth Moternity Pensions Unemployment lnjury

15.9 6.4 0.1 8.9 0.1 0.5

22.1 6.4 0.1 15.5 0.1

38.0 12.7 0.2 24.4 0.2 0.5

European Unionl

23.6

12.9

36.5

Western Europe4

22.1

1 1 .7

33.8

1 6.2

8.6

24.8

Czech Republic Heolth

Sickness Pensions Unemployment Hungory Heolthl

Pensions Unemployment Polond Sickness2

Disobility Pensions lnjury

OECD5

22.0

1.1

Sources: International Bureou of Fiscal Documentation; and World Bonk

13.7

4.8 27.5

4.0

( 1998).

11ncludes sickness contributions. 2Aiso indudes moternity contributions, and a heolth contribution poid by the employees.

3Unweighted average of the Europeen Union countries (exduding Denmark). 4Unweighted average of European Union countries (excluding Denmork) and lcelond, Norwoy, and Switzerlond. 5Unweighted average of Western Europe (os defined above) and Australie, Japon, Mexico, New Zeolond, and the United States.

Revenue generation from the persona! income tax (PIT) in some of the five countries is hampered by a vast system of deductions and ex­ emptions, and high tax rates. ln general, the PIT has a progressive struc­ ture of marginal rates, and the number of brackets is in line with the sys-

©International Monetary Fund. Not for Redistribution

A/J[>endix

Il

217

tems in the EU (Table A 7). The top marginal rares are around 40 rer­ cent ( wirh the exception of Slovenia: 50 percent), broadly in line with an EU average of 441h percent. However, low effective tax collection compared with the EU suggests a relatively narrow base. This can be at­ tributed, in part, to various tax credits and specifie exemptions. For ex­ ample, in contrast to the EU, interest on govemmenr bonds is exempt in the central European counrries, and interest on bank deposits is raxed only in the Czech and Slovak Republics, wh ile fully taxed (either as part of ordinary income or at separate rates) in ali EU countries. A Iso, in con­ rrast to many (but not ail) EU counrries, social security benefits are rax exempr.27 In addition, as noted above, high tax rares on labor income re­ duce employment in the official economy. Finally, the size of the gray economy in sorne countries only compounds problems already experi­ enced in strengthening tax administration.28 Corporate income tax rates and investmenr incentives diffcr signifi­ cantly across the accession candidates. Tax rates vary from 1 8 percent in Hungary to 3 1 percent in the Czech Republic; these compare with an average of about 33 percent for the EU (Table A8).29 The wide di\'er­ gence in tax rates of central European countries reflecrs ro a large cxrenr different strategies to attract foreign direct investment (FOI}, wirh some governments favoring special cax cream1enrs and nonrax incenrives."-' The latter have included a number of desirable measures, such as im­ proved legal and institutional frameworks, complemenred hy public sec­ tor reforms to enhance transparency and governance. However, ali five govemments have also adopted, to different degrees, discriminamry practices, including tax holidays and import dury exemptions for foreign

27This implies rhar the effective tax ratio would be highcr in tho.: central Eurol'Cdn coun­ tries (or lower in the EU), if derived on a comparable basis. 28Lacko ( 1995) esrimared thar rhe size of rhc hidden economy in Hungarv wa' Jt1 rer­ cent of official GOP in 1990 and thar it increased by 4-5 percemagc point:- hctwcen 1990 and 1993. l n Slovakia, official statistics point co a gray economy nf