Robert Read: Eastward Expansion of the EU & European Monetary Union

Chapter 2:

Eastward Expansion of the EU & European Monetary Union

Robert Read

The eastward expansion of the European Union is set to take place over the first decades of the 21st Century and will include many, if not eventually all, of the former Eastern Bloc and/or their successor states. Eastward enlargement therefore has a critical strategic dimension (discussed in Chapter 3). In addition, there are also important economic implications for both existing EU Member States and the acceding countries. These have principally been taken to encompass the interaction between the effects of trade and economic growth (see Chapters 6 & 7). A key theme of EU policy from the late 1980s however, has been macroeconomic convergence and policy co-ordination, leading to the introduction of the Euro in January 1999 and the elimination of national currencies in Euroland in 2002. Perhaps surprisingly in this context, there has been very little consideration to date of the conjunction between Eastward enlargement of the EU and its implications for Monetary Union, specifically the single currency.

This Chapter is intended to provide an overview of the major issues relating to the prospective incorporation of the acceding countries of Central & Eastern Europe into the Euro Zone. Any such analysis must consider the economic structures of the applicant countries in terms of production and trade in the context of insights and issues relating to economic theories of monetary union. Section I outlines the key structural characteristics of the economies of the ten Central & Eastern European (CEE) applicants, henceforth referred to as the CEE-10, and their evolution since economic reform after 1989. This is followed by a summary of the economic theory of monetary integration, including the benefits and costs of monetary union, optimal currency area theory and the extent to which the existing EU satisfies the criteria for a monetary union. Section III addresses issues arising in the context of CEE-10 participation in the Euro Zone, including an assessment of the benefits and costs of membership, insights from German monetary unification and CEE-10 macroeconomic performance since transition. The final Section considers the prospects for CEE membership of the Euro Zone after EU accession with respect to macroeconomic convergence and policy co-ordination

I. The Economic Structure of the CEE-10 Applicant Countries

All of the CEE applicant countries have only recently emerged from almost five decades of central planning. The growth process under central planning was essentially autarkic in spite of their role as economic satellites of the former Soviet Union through Comecon. Economic reform and the process of transition to more ‘market-oriented’ Western-style economies was only initiated after 1989 in the wake of fall of the Berlin Wall and the subsequent collapse of the Soviet Union. Economic (together with political and social) transition is therefore only a recent phenomenon and very much an ongoing process in these nascent economies.

The economic analysis of monetary union and the implications of the introduction of a shared currency between countries is dependent upon comparative data relating to the structure of economic activity and patterns of consumption in potential member states. This Section provides summary data and a discussion of the key economic structural characteristics of the CEE-10 European applicant countries. The economies under discussion are: the three Baltic states, Estonia, Latvia and Lithuania; the four Visegrad states, the Czech Republic, Hungary, Poland and Slovakia; Bulgaria, Romania and Slovenia. Further, the prospective accession of the CEE-10 economies to the EU is addressed in the context of the economic theory of integration.

I.1 Population, GDP Growth & Per Capita Incomes, 1989-99

In 1999, the ten CEE applicant countries had a combined population of just under 105 million, little more than a quarter of that of the current EU-15 population, and a land area of one third of the EU (see Table 1). The demographic profile of the CEE since 1989 has generally been characterised by low rates of population growth or, in several cases, even decline as a result of migration and low rates of replacement. In aggregate terms therefore, the population of the CEE-10 has hardly changed since transition began.

[Table 1 here]

The economic performance of the CEE-10 since 1989 has been very mixed. Average annual real GDP growth rates between 1989 and 1994 were negative across-the-board, with very significant declines in the three Baltic states as well as Bulgaria. Romania and Slovakia (see Table 2). The period from 1995 to 1999 however, saw an improved growth performance in all of the CEE-10 economies and a strong economic recovery in some. Nevertheless, the conflict in Kosovo had a dampening effect on growth, particularly in Bulgaria and Romania while the effects of the 1998 Russian economic crisis affected growth in the Baltic states adversely. Negative GDP growth persisted in only Bulgaria and Romania. Nevertheless, it is evident from the economic data in Table 2 that six of the CEE-10 experienced a real decline in GDP over the whole period 1989 to 1999 and that only Hungary, Poland, Slovakia and Slovenia enjoyed any real improvement in their aggregate GDP.

[Table 2 here]

There are several explanations for the poor economic performance of the CEE-10 between 1989 and 1999. There can be little doubt however, that the principal factor has been the process of economic and institutional transition necessitated by their structural transformation from centrally-planned command-based to more market-oriented economies. This process has involved the reduced economic role of the State, including privatisation, the drastic reduction or complete withdrawal of subsidies to loss-making ventures, the reorganisation and retraining of management and the introduction of market-based prices and contracts for inputs, including wages, and output. The effect of all of these changes has been to reduce domestic aggregate economic activity, at least in the short-run. In addition, the collapse of the Comecon trading system coupled with economic transition in Russia and the rest of the Commonwealth of Independent States (the former Soviet Union) closed-off many of the established export markets of the CEE-10. The intrinsic lack of competitiveness of many CEE-10 exports meant that they were unable to take immediate advantage of opportunities in many non-traditional export markets, especially in the EU and the US. The poor growth performance of the EU-12 and EU-15 economies in the 1990s was also an important factor since they have come to represent a critical export market for the CEE-10. Sluggish aggregate demand, the extremely deflationary impact of the Maastricht convergence criteria and the restructuring engendered by the introduction of the Single European Market all combined to inhibit the potentially beneficial demand-pull effects of the EU market on CEE-10 exports.

The evolution of per capita incomes at PPP in the CEE-10 does not appear to have been as severe as might be expected given the performance of GDP. From the data in Table 2, per capita incomes have increased in six of the CEE-10 - significantly in the cases of the Czech Republic, Hungary, Romania and Slovenia, and declined marginally in three – and only significantly in Latvia. This data is, to some extent, contradictory with the GDP growth figures in the Table and suggests that caution should be exercised. The data is drawn from different sources with potentially conflicting methodologies and estimates of PPP per capita incomes in the CEE-10 prior to transition are notoriously prone to significant errors. Nevertheless, the underlying trend may well be robust given that the data measures real standards of living and excludes the Government sector, the share of which in GDP has declined significantly over this period.

I.2 The Structure of Economic Activity & Employment, 1989-99

The command-based system of central planning which operated in the CEE economies until 1989 placed undue emphasis upon relatively autarkic industrialisation based upon the development of large-scale heavy industries. The allocation of non-resource-based industrial activity, both among countries and between sub-national regions as well as prices and output, were determined by political criteria rather than the efficiency criteria of market-oriented economics. The actual structure of economic activity and employment extant in the CEE-10 by 1989 was thus only incidentally related to the fundamental pattern of international comparative advantage. A critical element of the transition process of the CEE-10 economies since 1989 therefore, has been the transformation of their economic structures through market-oriented reforms and the promotion of patterns of economic activity and employment which more closely reflect underlying comparative advantage. This structural transformation is intended to improve the stability and robustness of the CEE economies as well as enhancing their international competitiveness.

It is also important to compare the economic structure of activity and employment of the CEE-10 directly with that of the EU-15. It is clear from Table 3 that the share of agriculture in GDP and employment in the CEE-10 in 1999 is significantly higher than in the EU as a whole. Gross value added in agriculture in the CEE-10 averaged 5.8 percent in 1999 compared with less than 4 percent in the EU-15. Nevertheless, the shares of the five ‘fast-track’ CEE entrants – the Czech Republic, Estonia, Hungary, Poland and Slovenia, at below 5 percent are more or less comparable with Ireland, Portugal and Spain and very much lower than for Greece. There is however, a much greater dissimilarity in the sectoral pattern with respect to employment in which the CEE-10 had an average of 20.7 percent in 1999 compared with the EU-15 average of around 5 percent. The share of agricultural employment is below 10 percent in only four CEE-10 countries – the Czech Republic, Estonia, Hungary and Slovakia. The evolution of the sectoral structure of gross value added and employment in the CEE-10 between 1995 and 1999 is shown in the Table. The decline in the share of both industrial gross value added and employment in most CEE-10 economies between 1995 and 1999 can be attributed directly to the impact of transition.

[Table 3 here]

I.3 The Structure & Pattern of CEE Trade, 1989-99

The pattern of international trade of the CEE-10 economies has undergone significant structural change in the period 1989 to 1999 in terms of their principal trading partners, the volume and value of trade and the commodity structure of trade. This is in part the outcome of the effect of the Europe Agreements but also a reflection of domestic structural transformation and the increasing outward orientation of the CEE economies. In the first years of transition in the early 1990s, each of the CEE countries signed individual Association Agreements with the EU. Generally referred to as the Europe Agreements, they are very similar to other Association Agreements signed between the EU and prospective member states. They are basically trade and aid agreements establishing a framework for political dialogue and bilateral free trade on a hub and spoke system, ie with the EU at their centre. In addition, the EU pressed the applicant CEE economies to form their own free trade agreement, leading to the creation of the Central European Free Trade Association – CEFTA, covering Bulgaria, the Czech Republic, Hungary, Poland, Romania, Slovakia and Slovenia, and the Baltic Free Trade Agreement – covering Estonia, Latvia and Lithuania.

The overall trade performance of the CEE-10 economies is shown in Table 4. It is clearly evident from the trade data 1995-99 that there has been significant growth in the nominal Euro value of both imports and exports for nearly all of the CEE-10 economies. This is particularly notable in the cases of the five ‘fast-track’ economies, possibly excluding Slovenia, together with Latvia, Lithuania and Slovakia. Only in the case of Bulgaria has there been negative growth. The growing importance of international trade to the CEE-10 economies is also reflected in their increasing openness measured by the greater share of trade (exports + imports) in GDP. There have been significant increases in the degree of openness to trade in the cases of the Czech Republic, Hungary, Poland and Slovakia and a significant decrease only in the case of Lithuania. A note of warning however, is provided by the trade balance data, given the magnitude of the accumulated trade deficit of the CEE-10 economies, 1995 to 1999. Only in the case of Bulgaria is the accumulated deficit over the last five years less than one billion Euros. The accumulated trade deficits of nearly all of the CEE-10 economies, including the five ‘fast-track’ states, are unsustainable since they constitute a substantial proportion of annual GDP. That is, there will need to be a significant adjustment in the balance of CEE-10 trade in the near future in the absence of sufficient external financing, whether in the form of direct investment (FDI) or foreign loans. It can be argued that at least part of the growth of CEE-10 imports is likely to be in capital goods, in the form of machinery, technology and know-how, which will improve the fundamental competitiveness of their output and exports through increased productivity. A failure to remedy this situation can be expected to lead to a rapid deterioration of the foreign exchange position of the CEE-10 economies with an adverse impact on their currencies relative to the Euro and US Dollar.