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Enlargement of the EU and of the
th
European Monetary Union
– Final Project Report –
efan DETSCHER - Carlos MATOSO - Alexander REGELMANN - Francisco RHODE
INTERNATIONAL FINANCE
CERAM, Sophia Antipolis, Autumn Semester 2002
22.11.2002
Enlargement of the EU and of
the European Monetary Union
Project‘s objective
Special Focus:
International financial impacts on the candidate countries
Financing of the enlargement
Consequences for the EMU and the Euro currency
Key Question:
Does the enlargement make sense under international financial aspects?
Semester 2002
Enlargement of the EU and of
the European Monetary Union
Project Contents
1. EU/EMU in General
2. Maastricht Criteria + Convergence
3. Impacts on Candidate Countries
4. How to finance Enlargement
5. Monetary Policy Aspects of the Enlargement of the EMU
6. € Stability/ Exchange Rates
7. Conclusion
Semester 2002
Enlargement of the EU and of
the European Monetary Union
AGENDA
1. EU/EMU in General + Accession Scenarios
2. Maastricht Criteria + Convergence
3. Impacts on Candidate Countries
4. How to finance Enlargement
5. Monetary Policy Aspects of the Enlargement of the EMU
6. € Stability/ Exchange Rates
7. Conclusion
Semester 2002
Enlargement of the EU and of
the European Monetary Union
European Monetary Union - Members
Starting date: 1 January 1999
Founding Members: France, Germany, Italy, Spain, Netherlands,
Belgium, Austria, Portugal, Irland,
Finland,Luxembourg
Later Entrant: Greece (1 January 2001)
Non-participants: UK, Sweden, Denmark
Semester 2002 1. EU/EMU in General + Accession Scenarios
Enlargement of the EU and of
the European Monetary Union
Candidate Countries
10 candidates entering date announced:
Poland, Hungary, Czech Republic,
Slovakia, Estonia, Latvia, Lithuania,
Slovenia, Cyprus, Malte
2 candidates entering later:
Bulgaria, Romania
1 candidate without
projected entering date:
Turkey
Semester 2002 1. EU/EMU in General + Accession Scenarios
Enlargement of the EU and of
the European Monetary Union
Accession Scenarios
Two assumed scenarios of EU enlargement process:
1.) Baseline Scenario (75%): Large Convoy in 2004/2005
Eight Eastern European countries join EU in 2004/2005: Hungary,
Slovenia, Poland, Czech Republic, Slovakia, Estonia, Latvia, Lithuania
(plus Malta and Cyprus).
Source: Deutsche Bank
Semester 2002 1. EU/EMU in General + Accession Scenarios
Enlargement of the EU and of
the European Monetary Union
Accession Scenarios
2.) Alternative Scenario (25%): Small Convoys
Because of heterogeneous progress in preparations on part of the
accession countries and/or lacking readiness to enlarge on part of the
EU, the candidates join in different groups
Hungary, Slovenia, the Czech Republic and Estonia join in 2004,
Poland, Slovakia, Latvia and Lithuania not before 2006
Source: Deutsche Bank
Semester 2002 1. EU/EMU in General + Accession Scenarios
Enlargement of the EU and of
the European Monetary Union
AGENDA
1. EU/EMU in General + Accession Scenarios
2. Maastricht Criteria + Convergence
3. Impacts on Candidate Countries
4. How to finance Enlargement
5. Monetary Policy Aspects of the Enlargement of the EMU
6. € Stability/ Exchange Rates
7. Conclusion
Semester 2002
Enlargement of the EU and of
the European Monetary Union
Maastricht Criteria (1998)
1. Price Stability
maximal 1,5% above average of three most price stable EU members over
the preceding 12 month before convergence assessment
2. Exchange Rate Stability
participation in Exchange Rate Mechanism (ERM II) during at least 2 years
before convergence assessment without severe tensions, especially without
unilateral devaluation by a member country
3. Interest Rates 10y Bonds
maximal 2% above average of three best performing EU members
4. Public Deficit
maximal 3% of GDP per year
5. Public Debt
maximal 60% of GDP
Semester 2002 2. Maastricht Criteria + Convergence
Enlargement of the EU and of
the European Monetary Union
Maastricht Criteria Convergence
Source: Deutsche Bank
Current Reference Value: 3,2% ( = 1.7% + 1.5% )
Semester 2002 2. Maastricht Criteria + Convergence
Enlargement of the EU and of
the European Monetary Union
Structural Convergence - Convergence Webs
The webs illustrate the structural economic development of the candidate
countries measured against the EU average
The level of structural convergence is assessed on the basis of 16
indicators
The strengths and weaknesses of each country can be recognised at a
glance
Source: Deutsche Bank
Semester 2002 2. Maastricht Criteria + Convergence
Enlargement of the EU and of
the European Monetary Union
Structural Convergence – „Best-In-Class“ Countries
Source: Deutsche Bank
Semester 2002 2. Maastricht Criteria + Convergence
Enlargement of the EU and of
the European Monetary Union
Structural Convergence – „Best-In-Class“ Countries
Source: Deutsche Bank
Semester 2002 2. Maastricht Criteria + Convergence
Enlargement of the EU and of
the European Monetary Union
Structural Convergence – „Medium-Convergence“ Countri
Source: Deutsche Bank
Semester 2002 2. Maastricht Criteria + Convergence
Enlargement of the EU and of
the European Monetary Union
Structural Convergence – „Medium-Convergence“ Countri
Source: Deutsche Bank
Semester 2002 2. Maastricht Criteria + Convergence
Enlargement of the EU and of
the European Monetary Union
Structural Convergence – „Worst-In-Class“ Countries
Source: Deutsche Bank
Semester 2002 2. Maastricht Criteria + Convergence
Enlargement of the EU and of
the European Monetary Union
Convergence - Analysis
2002: Progress in difficult environment
Slovenia, the Czech Republic, Hungary
and Estonia have highest level of
convergence
Slovakia and Latvia follow with
convergence values at around 70% of
the EU average
Bulgaria and Romania have great need
for catch-up, but show remarkable
growth rates due to successful reform
policy
Source: Dresdner Bank
Semester 2002 2. Maastricht Criteria + Convergence
Enlargement of the EU and of
the European Monetary Union
AGENDA
1. EU/EMU in General + Accession Scenarios
2. Maastricht Criteria + Convergence
3. Impacts on Candidate Countries
4. How to finance Enlargement
5. Monetary Policy Aspects of the Enlargement of the EMU
6. € Stability/ Exchange Rates
7. Conclusion
Semester 2002
Enlargement of the EU and of
the European Monetary Union
Low price stability in CEE
Inflation rate, %
Source: Dresdner Bank
Current Reference Value: 3,2% ( = 1.7% + 1.5% )
Semester 2002 3. Impacts on Candidate Countries
Enlargement of the EU and of
the European Monetary Union
Large wealth gap between EU-15 and different candidate
Nominal GDP per capita (2000) in Euro Economic asymmetry in an
enlarged EU – based on % GDP
Candidate countries
5%
EU-15
countries
95%
Semester 2002 3. Impacts on Candidate Countries
Enlargement of the EU and of
the European Monetary Union
Foreign Trade of CEE = Trade Balance
History: Change of main trading partner: EU indeed of Russia
Status Quo: Strong export figures of CEE since 1990
Problem: Often only export of price sensible products
Solution: Structural reforms for being able to compete with higher
technological and higher quality products
Measures: FDI from EU-15 countries and the US
Development of local management structures
Structural change in agricultural sector and in textile industry
Objective: Higher level of value creation in production processes
Semester 2002 3. Impacts on Candidate Countries
Enlargement of the EU and of
the European Monetary Union
High current account balance deficits of CEE
Current Account Balance Deficits
% of GDP
Bulgaria Current account balance deficits of CEE in
Estonia 2001 between 3% and 7% of GDP
Latvia
Absorption approach: Y – A = X - M
Lithuania
high consumption quota and
Poland
low savings quota
Romania
⇒ higher absorption than production
Slovakia
⇒ higher imports necessary to cover demand
Slovenia
Czech
⇒ import excess
Republic
⇒ Trade balance deficit
Hungary
⇒ CAB deficit
Source: Dresdner Bank
Semester 2002 3. Impacts on Candidate Countries
Enlargement of the EU and of
the European Monetary Union
Financing of CAB deficits through FDI
Best solution because
no additonal foreign
debts
Improvement of future
growth perspectives
through capital and
technology transfer
Necessary action:
→ privatization and
deregulation
RISK:
Weakening of FDI when
large privatization projects
are finalized
Semester 2002 3. Impacts on Candidate Countries
Enlargement of the EU and of
the European Monetary Union
Up to now weak Portfolio investments
Main Reasons:
a) still instable markets
b) partly stock exchanges
under development
Strong Emerging Markets:
Estonia, Hungary and Czech
Republic
Positive Outlook for Bond
Market because of
a) falling interest rates
through convergence
phantasy
b) good ratings because of
low level of foreign debt
CHANCE: building up own capital stock
of CEE
RISK: more volatile capital account
Semester 2002 3. Impacts on Candidate Countries
Enlargement of the EU and of
the European Monetary Union
Trend: Accelerated Development of Candidate Countries
GDP: dynamic GDP growth
⇒ increased convergence with EU-15
Inflation: better price stability through
continuous structural reforms
Foreign Trade: no further export boom of CEE because of
decreasing wage level difference to EU-15
FDI: decreasing FDI because of finished
privatisation projects
Portfolio Investments: more portfolio investments because of further
developing financial intermediary systems and
improving structural environment
Semester 2002 3. Impacts on Candidate Countries
Enlargement of the EU and of
the European Monetary Union
AGENDA
1. EU/EMU in General + Accession Scenarios
2. Maastricht Criterias + Convergence
3. Impacts on Candidate Countries
4. How to finance Enlargement
5. Monetary Policy Aspects of the Enlargement of the EMU
6. € Stability/ Exchange Rates
7. Conclusion
Semester 2002
Enlargement of the EU and of
the European Monetary Union
Indicators of previous EU Enlargements
Source: Deutsche Bank
Semester 2002
Enlargement of the EU and of
the European Monetary Union
Who pays for the enlargement ?
Net contributor/ recipient position of EU-15 countries in € bn
Semester 2002
Enlargement of the EU and of
the European Monetary Union
What the Enlargement will cost
(All figures in million euro)
Source: Agenda 2000
Semester 2002
Enlargement of the EU and of
the European Monetary Union
Commission proposal for the financing of enlargement
“Common Financial Framework 2004-2006 for the Accession Negotiations”
(European Commission, Information Note January 2000). Main points:
1. Agriculture:
Fully integration of the new members in all market support schemes
Direct payments to farmers in the new member states are increased in steps
to 35% (2006) of the present support level (approx. euro 2.6 bn by 2006).
50% more per capita for rural development for new members
2. Regional Aid:
“Phasing-in”:
At the end of the transition phase:Total aid for new members equivalent to 2.5
of their GDP (existing cohesion countries receive 1.6%)
In total, all the payment appropriations to the new members will rise from
8.9 bn euro in 2004 to 14.2 bn euro in 2006 !
Semester 2002
Enlargement of the EU and of
the European Monetary Union
Financing procedure and costs of the enlargement
Contributions of EU 15:
Total appropriations for the enlargement: 4.1 bn € (02) -14.2 bn€ (06)
Equal market related subsidies for farmers
Obligations for the candidates:
Participation in structural funds to catch up differences in econonmic
standards.
Contributions to the EU-budget and “entrance fees” to EU bodies.
Consolidation of administrative capacities and infrastructure.
Semester 2002
Enlargement of the EU and of
the European Monetary Union
AGENDA
1. EU/EMU in General + Accession Scenarios
2. Maastricht Criterias + Convergence
3. Impacts on Candidate Countries
4. How to finance Enlargement
5. Monetary Policy Aspects of the Enlargement of the EMU
6. € Stability/ Exchange Rates
7. Conclusion
Semester 2002
Enlargement of the EU and of
the European Monetary Union
The Balassa Samuelson Effect - Introduction
When discussing the monetary impacts of
the EU-Enlargement there are often fears
of a uncontrollable increase in inflation
for the total European Union.
Those fears are generally based on the
Balassa-Samuelson-Model
The Balassa-Samuelson-Effect states
that an increase in prices are the
consequence of different productivity
advances in two sectors:
The tradable (exportable) goods’
sector
The non-tradable goods’ sector
Source: Deutsche Bank
Semester 2002 5. Monetary Policy Aspects of the Enlargement of the EMU
Enlargement of the EU and of
the European Monetary Union
The Balassa Samuelson Effect – Introduction (cont.)
Two sectors:
The tradable goods sector
As long as PPP holds for the traded
goods prices, an increase in
productivity in this sector will not
influence their price. Instead, in the case
of fixed exchange rates, or a monetary
union, nominal wages will rise.
The non-tradable goods’ sector
If wages develop similarly in the whole
economy , non-traded goods’ prices will
increase and therefore become
relatively more expensive.”
Source: Deutsche Bank
Semester 2002 5. Monetary Policy Aspects of the Enlargement of the EMU
Enlargement of the EU and of
the European Monetary Union
The Balassa Samuelson Effect - Assumptions
(1) The economy produces traded and non-traded goods.
(2) The supply side can be approximated by two (different) production functions,
in which capital and labour are used as inputs and which are characterized
by constant returns to scale.
(3) Purchasing Power Parity holds for the traded goods: their prices are
therefore given exogenously. => exogenously given
(4) Capital markets are integrated and the interest rate is thus determined in the
world => exogenously given
(5) Capital stock is fixed in the short run => exogenously given
(6) The labour market is homogeneous within the economy. Wages in the traded
goods sector are determined by the marginal product, and these wages hold
also for the non-traded goods sector => Total labour mobility in the economy.
Semester 2002 5. Monetary Policy Aspects of the Enlargement of the EMU
Enlargement of the EU and of
the European Monetary Union
The Balassa Samuelson Effect - Calculation
Two sectors have to be distinguished:
a) Tradable goods:
Profit – Function: P = AT F(CT, LT) – w LT – r CT
- modified: P/ LT = AT f(cT) – w – r cT whereas cT =CT / LT
b) Non- tradable goods:
Profit – Function: P = p AN G(CN, LN) – w LN – r CN
- modified: P/ LN = p AN g(cN) – w – r c N whereas cN = CN / LN
A = Productivity; L= Labor; w= Wages; r= interest rate; C = Capital
p= price of a non-tradable good in units of a tradable one
Semester 2002 5. Monetary Policy Aspects of the Enlargement of the EMU
Enlargement of the EU and of
the European Monetary Union
The Balassa Samuelson Effect – Calculation (cont.)
Set to zero and rearrange modified Profit Functions:
AT f(cT) = r cT + w (1) tradable goods’ sector
p AN g(cN) = r c N+ w (2) non-tradable goods’ sector
After Logarithm and total Differentiation (derive to AT (AN), cT(c N), p and
w):
∆ AT = µLT ∆w (from 1)
∆p + ∆ A N = µLN ∆w (from 2) whereas µL,i= w Li / Yi
∆ AT = growth rate of productivity for tradable goods
∆ A N = growth rate of productivity for non-tradable goods
∆w = growth rate of wages
µL,i = ratio between sum of wages and Output in sector i
∆p = growth rate of prices of non-tradable goods
Semester 2002 5. Monetary Policy Aspects of the Enlargement of the EMU
Enlargement of the EU and of
the European Monetary Union
The Balassa Samuelson Effect - Calculation (cont.)
µLN
∆p = ___ ∆ AT – ∆ A N ∆p = Increase in prices in service sector
µLT
∆ A = Productivity advance
µL = Labor intensity
So if µLN > µLT a higher productivity advance in the tradable goods’ sector
leads to higher prices in the non-tradable goods’ sector
The increase in prices is the higher the larger the share of labor in the non-
tradable goods’ sector is relative to the share of labor in the tradable goods’
sector
Semester 2002 5. Monetary Policy Aspects of the Enlargement of the EMU
Enlargement of the EU and of
the European Monetary Union
The Balassa Samuelson Effect - Example
µLN ∆A = Productivity Advance
____
∆p= µLT ∆AT – ∆AN µL = Labor Intensity
∆p = Increase in prices for services
Labor intensity is always defined as total wages (wages x employees) divided by
the total output in the concerned sector.
Ex: Assume a labor intensity in the service sector of 0.4 and a labor in-
tensity of 0.35 in the tradable goods’ sector. Productivity grows by 5%
in the tradable good sector, there is no advance in the service sector.
0.4/0.35 x 5% - 0% = 5.71 % (increase in prices for services)
In this case, prices for non-tradable goods will increase by 5.7 % if there is
no productivity advance in the service sector. The overall inflation for the
concerned country strongly depends on the weight of the service sector in
the economy.
Semester 2002 5. Monetary Policy Aspects of the Enlargement of the EMU
Enlargement of the EU and of
the European Monetary Union
The Balassa Samuelson Effect – Possible scenario
T-Sector Increase
Price Stabilit
in Productivity
Competition,
Open Markets
EU-Enlargement Rising Wages
NO Increase
Inflation
in Productivity
NT-Sector Unemploymen
Social Instabilit
Instabili
Semester 2002 5. Monetary Policy Aspects of the Enlargement of the EMU
Enlargement of the EU and of
the European Monetary Union
The Balassa Samuelson Effect - Results
High productivity advances in the Eastern European Countries are
expected after the enlargement as a consequence of increased
competition and liberty.
Since this productivity advance only concerns the tradable goods‘
sector overall rising wages will cause high inflation rates in these
countries.
The increase in prices in the sector of non-tradable goods will cause
higher unemployment in Eastern Europe (normal price elasticity
assumed). These negative employment effects mainly concern
services or agriculture.
Semester 2002 5. Monetary Policy Aspects of the Enlargement of the EMU
Enlargement of the EU and of
the European Monetary Union
AGENDA
1. EU/EMU in General + Accession Scenarios
2. Maastricht Criterias + Convergence
3. Impacts on Candidate Countries
4. How to finance Enlargement
5. Monetary Policy Aspects of the Enlargement of the EMU
6. € Stability/ Exchange Rates
7. Conclusion
Semester 2002
Enlargement of the EU and of
the European Monetary Union
Currency regimes and exchange rates of the candidates
(European Exchange Rate Mechanismen II)
Source: Deutsche Bank
Semester 2002 6. € Stability/ Exchange Rate
Enlargement of the EU and of
the European Monetary Union
Fears: The impact of the enlargement on the Euro
The EU enlargement is very often criticized as a risky project which may
destabilize the Euro and therefore the whole EMU because of the following
reasons:
An as unclear perceived enlargement process
An anxiety about the monetary and economic stability of an
enlarged European Union
Structural divergences between the candidate countries and the
EMU
A lack of political transparency within the EU
Are these fears justified ?
Semester 2002 6. € Stability/ Exchange Rate
Enlargement of the EU and of
the European Monetary Union
Is the Enlargement Process clear and transparent ?
Steps in the enlargement process:
At least 3 years Maastricht criteria Permanent control
between EU accession The convergence pro- of the economic policy
and EMU membership... gress of each new mem- of the new members by
ber country decides how the EU commission …
long it must wait to join
the EMU …
There is enough time to prepare for the EU
and EMU enlargement.
Semester 2002 6. € Stability/ Exchange Rate
Enlargement of the EU and of
the European Monetary Union
Economic divergences – a source of risk ?
Real economic divergences are mostly pointed out as the main problem
when talking about possible difficulties of the enlargement. Two
arguments:
Problem : Different GDP growth rates
Answer:
The convergence criteria help to limit the impact of
different economic cycles within the EU. Different
economic developments have to be beard by the
individual member states since the monetary po-
licy of the ECB concerns the price stability of
the whole Union.
Semester 2002 6. € Stability/ Exchange Rate
Enlargement of the EU and of
the European Monetary Union
Economic divergences – a source of risk ? (II)
Problem: Low income level in candidate countries will require high
transfer payments
Answer:
Experience shows that lower income levels are no
obstacle for a successful participation in the EU
and the EMU (e.g. Greece, Portugal). Because
of the pressure of the strong EU-members
a significant increase in transfer payments
is not very likely.
Semester 2002 6. € Stability/ Exchange Rate
Enlargement of the EU and of
the European Monetary Union
Further aspects concerning the Euro stability
Investments: Positive impacts on the exchange rate because
of new attractive possibilities for FDIs and port-
folio investments.
Economy of candidates: Low economic weight of the candidate
countries
Institutional paralyzing: Institutional reforms are necessary to prevent
the paralyzing of political decision processes
(EU convent in Laeken, Finland)
Semester 2002 6. € Stability/ Exchange Rate
Enlargement of the EU and of
the European Monetary Union
Answers: The impact of the enlargement on the Euro
The enlargement process is well defined; the
EMU participation is obligatory
ECB controls monetary stability
Maastricht criteria limit the negative impacts
of structural divergences
Institutional reforms are essential and have to
be continued
Semester 2002 6. € Stability/ Exchange Rate
Enlargement of the EU and of
the European Monetary Union
AGENDA
1. EU/EMU in General + Accession Scenarios
2. Maastricht Criteria + Convergence
3. Impacts on Candidate Countries
4. How to finance Enlargement
5. Monetary Policy Aspects of the Enlargement of the EMU
6. € Stability/ Exchange Rates
7. Conclusion
Semester 2002
Enlargement of the EU and of
the European Monetary Union
Chances-Risks Analysis of EU/ EMU Enlargement
CHANCES RISKS
Larger European domestic
market Discrepencies between
expectations of people in
More investment possiblities Western and Eastern
with lower transaction costs European Countries
Higher economic growth Big differences between
opportunities income levels
Higher political and Problems of work force
econmical stability in Europe migration
Higher international Euro stability
recognition of EU
Problem of high subsidies
Higher significance of
stronger Euro as reserve, Inflation pressure
trade and investment
currency
Semester 2002 7. Conclusion
Enlargement of the EU and of
the European Monetary Union
Conclusions and Recommendations
Harmonize structures in EU-15
and candidate countries
Accelerate convergence
process Enlargement will cost about €40b
Reduce subsidies (especially Prepare institutions through
EU / EMU
agricultural subsidies) reforms
Enlargement
Further deregulation and Price level adoption of CEE caus
privatization higher inflation in enlarged EU
Euro stability is not in danger if
Maastricht criteria are observed
RESULT: enlargement makes sense under international financial aspect
Semester 2002 7. Conclusion
Thank you for your
attention !
22.11.2002
