Life after the hangover: Economic growth in the new EU member states between accession boom and adjustment bust

Uwe Böwer Alessandro Turrini European Commission DG Economic and Financial Affairs 25 June 2009

1

Agenda

     Motivation: Accession boom and adjustment bust The EU growth effect in the literature Assessing the accession boom – Growth regressions – Cross-country variation in model predictions Growth implications of external adjustment – Competitiveness developments – Currency misalignment and growth regressions Conclusion 2

20 15 10 5 0 -5 -10

GDP growth from boom to bust

Estonia Lithuania Romania Latvia Bulgaria 18 16 14 12 10 8 6 4 2 0 Czech Republic Hungary Poland Slovenia Slovakia 3

Beta and sigma convergence

10 9 8 2 1 0 7 6 5 4 3 0 EE LV PL BG LT SK HU CZ PT IE SI EL ES FI UK NL SE AT EU2 7 CY FR BE M T IT DE DK Initial per capita income (1996) 5000 10000 15000 20000 25000 45 40 35 30 25 20 15 10 5 0 EU OMS NMS 4

Investment and trade

40 35 30 25 2008 1999 20 15 10 5 0 R om an ia B ul ga ri a Sl ov en ia E st on ia L at vi a Sl ov ak ia L ith C ua ze ni ch a R ep ub lic Po la nd C yp ru s H un ga ry M al ta 200 180 160 140 120 100 80 60 40 20 0 2008 1999 M al ta Sl ov ak ia H un ga ry E C st on ze ia ch R ep ub lic B ul ga ri a Sl ov en ia L ith ua ni a C yp ru s L at vi a Po la nd R om an ia 5

Quality of the legal system

8 7,5 7 6,5 6 5,5 5 5 RO 5,5 CY EE LT LV SK CZ BG 6 6,5 PL 7 MT HU SI 7,5

1999

8 6

The EU growth effect in the literature

 Crespo-Cuaresma et al. (2002) – Pre-2004 enlargements – Length of EU membership positive and significant  Schadler et al. (2006) – Growth determinants of transition countries – Importance of institutional quality  Cihak and Fonteyne (2009) – Regression over 10 years – “EU membership growth dividend” ~ 1-2.5% 7

Assessing the accession boom

   Panel dataset – 62 advanced and emerging economies – Annual data 1960-2009, 5-year averages Standard growth determinants – Real per-capita GDP growth – Initial real GDP (PPP) – Gross fixed capital formation – Population growth – Openness, terms-of-trade growth – Human capital formation Control dummies (time periods, country groups) 8

Enlargement-specific variables

   Institutional indices – Quality of the legal system – Freedom of trade – Quality of regulation NMS dummy Time/region interaction dummies – Difference-in-difference approach – Reference: EU-15 during 1995-1999 – Interacting NMS*(1990-94), NMS*(2000-2004), NMS*(post-2005) 9

Regression results (1)

Log initial per capita GDP Population growth Gross capital formation Openness Years of schooling Terms of trade growth Quality of legal system Freedom of trade Quality of regulation (1) 1960-2008 (2) -1.62*** (-5.28) -0.53** -1.10*** (-4.75) -0.69*** (-2.25) 0.19*** (8.45) 0.01*** (3.47) 0.26*** (3.38) (-2.98) 0.17*** (7.74) 0.01*** (3.04) (3) 1960-2008 (4) -1.35*** (-4.20) 0.06

-1.53*** (-5.07) -0.59** (0.16) 0.18*** (5.64) 0.01*** (3.19) (-2.01) 0.16*** (6.54) 0.01** (2.07) (5) 1990-2008 -1.39*** (-3.62) -0.46

(-1.38) 0.16*** (5.54) 0.01

(1.09) 0.16** (2.37) 0.12*** (2.95) 0.20

(1.55) 0.24* (1.94) 0.10

(0.50) 0.10* (1.89) 0.26

(1.57) 0.33* (1.82) -0.11

(-0.42) 10

Regression results (2)

NMS (dummy) NMS during 1990-1994 (dummy) (1) 1960-2008 (2) NMS during 2000-2004 (dummy) NMS after 2005 (dummy) Sample size Adjusted R² 254 0.57

254 0.54

(3) (4) 1960-2008 -1.57* -1.44

(-1.72) -3.56** (-2.55) 3.03*** (3.03) 2.14** (2.24) 305 0.47

(-1.61) -0.68

(-0.42) 2.87*** (3.01) 1.82* (1.95) 289 0.53

(5) 1990-2008 -1.28

(-1.32) -0.72

(-0.42) 3.13*** (3.13) 2.07** (2.17) 208 0.52

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Actual and predicted growth rates

Actual growth Predicted growth 9 6 5 8 7 0 -1 -2 2 1 4 3 Bulgaria Czech Republic Estonia Hungary Latvia Lithuania Poland Romania Slovakia Slovenia 12

Competitiveness developments

Bulgaria Cyprus Czech Republic Estonia Hungary Latvia Lithuania Poland Romania Slovak Republic Slovenia 1995 2000 2005 2010 1995 2000 2005 2010 1995 2000 2005 2010 1995 Year Real effective exchange rate 2000 2005 2010 Relative productivity index 13

Current account imbalances

Bulgaria Cyprus Czech Republic Estonia Hungary Latvia Lithuania Malta Poland Romania Slovak Republic Slovenia 1995 2000 2005 2010 1995 2000 2005 2010 1995 Year Current account balance 2000 2005 2010 1995 2000 2005 2010 Current account norms 14

Misalignment and growth literature

 Rodrik (2008) – Undervaluation stimulating growth – Effect driven by developing countries – Institutional weakness harming the tradable sector in poor countries  undervaluation as second-best – PPP-based misalignment measure  Freund and Pierola (2008) – Misalignment effect on export competitiveness – Export surges in developing countries preceded by significant undervaluations – Resource allocation: depreciation leadas more firms to expand product and market space for exports 15

Real exchange rate misalignment

  PPP versus current-account based misalignment Current account norms approach – Equilibrium REER: internal and external balance – Actual current account, adjusted for the cycle – Estimating a benchmark CA   Panel regressions of CA determinants In-sample fitted values as CA norm  Misalignment: required change in the REER to close the current account gap 16

CA regression results

Dependent variable: current account/GDP Explanatory variables Government budget balance/GDP Old-age dependency ratio Real GDP per capita in PPP term relative to US Growth rate in GDP per capita Initial NFA/GDP Oil balance Interaction monetary union dummy* Real GDP per capita in PPP term relative to US Constant 0.236*** (3.19) -0.150*** (-2.99) 2.213* (1.91) -0.318*** (3.02) 0.057*** (7.24) 0.004*** (3.95) N. observations R squared (within-R squared if fixed effects included) 2.731*** (3.16) 324 0.40 17

Misalignment and growth results

Misalignment Misalignment*openness Misalignment*per capita GDP Misalignment*transition dummy Misalignment (lagged) (1) -0.02

(-1.14) (2) -0.06*** (-3.12) -0.09*** (-3.72) (3) -0.02

(-1.26) 0.03** (2.18) (4) -0.01

(-0.11) (5) -0.06*** (-2.62) -0.07*** (-2.63) -0.15*** (-4.79) 0.02

(1.61) 18

Implications of misalignment results

   Overvaluation indicating less productive sectoral allocation (non-tradables) Undervaluation promoting growth (tradables) as a second-best option in the presence of institutional weaknesses (Rodrik) From adjustment bust to boom? – Negative growth impact in the short run – Benefits from sectoral reallocation in the longer term 19

From accession boom to adjustment bust, and then what?

     Catching up: beta and sigma convergence Significant impact of EU accession period, on top of variety of control variables Actual growth rates exceeding, then undercutting model predictions Substantial external imbalances and misalignments Misalignment based on current account norms indicates – Negative effect of overvaluation, mostly for open, poor and transition countries – Positive adjustment effect in the longer term  Implications for NMS: rebalancing current accounts will imply reduced investment financing in short-to-medium run but could be beneficial to stronger growth in longer run as the tradable sector expands 20