Challenges Ahead: Integrating Europe's New Members

Mr Chairman, Ladies and Gentlemen, thank you for the opportunity to join you today and to make some introductory remarks at this important session.

Before providing a brief overview of some of the economic policy issues raised by accession, I want first to emphasize an important underlying theme: namely, that accession is part of broader picture of economic evolution for the countries concerned. Accession involves candidate countries, as new members of an existing union, submitting themselves to an externally given set of rules, but rules which necessarily evolve over time and which the new entrant will have a chance to help shape in the future.

In this respect, accession can be viewed as a continental analogue of the broader process of globalization that is under way across the world. As countries integrate themselves into the world economy - removing barriers to flows of goods, services and capital - so they find themselves constrained by the norms and rules of the clubs they have chosen to join. In some cases, the rules are enforced by the international community itself through global institutions like the WTO and the IMF. In the case of the Fund, membership amounts to the acceptance of principles of good economic citizenship. And in return for embracing those principles, the Fund provides a forum for the discussion of the policies of all Fund members and of the international financial system itself and, in times of difficulty, it is prepared to extend financial assistance as well. Financial markets can also provide a separate and powerful mechanism that helps impose discipline on policymakers, although, as we have seen from time to time, market reactions can sometimes be larger and more volatile than changes in economic fundamentals may warrant.

So when we think about the requirements of accession, we should bear in mind that a good deal of what needs to be done - and much of what has already been done - would have been required in any event by integration into the global economy.

To point out the constraints imposed by global and regional integration is not to deny the enormous benefits that flow from them. Experience shows openness to trade, investment and other capital flows to be an effective way of helping to promote long-term economic success. I would recall that there has been no country that has made major strides in improving its economic situation over a sustained period of time other than by adopting open, market-oriented policies and integrating itself firmly into the international economy.

It is also important for current EU members, in deciding how rigidly to enforce the acquis on its new members, to think about how their own rules and norms are likely to have to adapt as globalization proceeds. The goal for existing and aspirant members alike should be an accession process that goes with the grain of globalization, and not against it. The Common Agricultural Policy is a case in point. Bringing the accession countries into an unreformed CAP may help limit the internal adjustment required in the short-term, but at the same time it will likely increase the adjustment required in the longer term to more powerful - and beneficial - external trends in the global economy.

Let me now briefly discuss the impressive economic performance of the accession economies to date, before addressing four of the key policy areas where accession will require further progress and adjustment in the future.

The transition from the various forms of central planning which characterized the countries now poised for accession to the EU to functioning market economies has not been easy. Nonetheless, most of these countries have generally fared better than others around the world that started the transition process at around the same time.

To varying degrees, in most transition economies output and employment dropped - sometimes sharply - and inflation surged in the first years of the transition process. Even now, output in most of these countries is only just regaining the levels seen immediately before transition began. But for the most part, stabilization was achieved relatively swiftly in the EU accession countries. Moreover, substantial underlying changes were taking place and, as a result, the structure of output is now much different than before transition and better aligned with countries' comparative advantage.

So why have the EU accession countries in the main performed so well relative to other transition economies, especially in the former Soviet Union? Good macroeconomic policies and ambitious structural reforms are important parts of the explanation. For example, many countries made a determined effort early in the process to impose hard budget constraints and stem quasi-fiscal losses. This was accomplished through a variety of routes, including fairly rapid privatization. Progress on structural reform is evident in a variety of comparative indicators:

· For example, the EBRD's transition indicators, which attempt to measure the extent of structural reform across a large number of policy areas, show that (with only a few exceptions) the EU accession countries are well ahead of the broader group of transition economies and on a par with non-transition economies at about the same income level.

· Another recent study, reported in the IMF's World Economic Outlook, examines institutional quality. This shows the EU accession countries well ahead of most other transition economies, particularly as regards democratization and the extent of public regulation and control. The quality of institutions actually appears to be higher on average in the advanced EU accession countries than in upper middle income developing countries as a whole.

· More specific measures show a similar movement towards the characteristics of a fully-developed market economy:
o The private sector share of GDP in most EU accession countries as a whole is now at least 70 percent;
o Around two-thirds or more of accession country exports are now directed to non-transition countries, mostly in western Europe. This is evidence of significant progress in reintegrating the accession countries into the broader European economy;
o In the majority of advanced EU accession countries, most large scale public enterprises have been privatized. Small scale privatization, of course, started early on and, in some cases, proceeded with dramatic speed.

The IMF and other international institutions monitor structural and other policy performance in all member countries on an ongoing basis. In the banking and financial sector this is done through the Financial Sector Assessment Program. In these and other areas, the progress of countries in adopting and implementing a variety of internationally agreed norms and best practices is assessed in what we call ROSCs or Reports on the Observance of Standards and Codes. The policy areas covered include statistical dissemination, monetary and fiscal transparency, corporate governance, and accounting and auditing.

Participation in these various policy health checks is voluntary and it is notable that, in many cases, accession countries have been more willing to subject themselves to scrutiny in this way than the current members of the EU, let alone other transition and developing countries. For example, the 13 EU candidates account for a quarter of all ROSC modules completed to date, compared to less than a tenth for the current EU-15. Candidate countries also participate in the Financial Sector Assessment Program at a higher rate than their future EU brethren.

In addition to policy reform, the advanced accession economies also owe their success in part to their physical proximity to the West. Relative to other transition economies, they also have more recent memory - and even some limited experience - of life as market economies. Both factors have facilitated a more rapid reorientation of trade than has been possible in countries further from western Europe and with a longer tradition of central planning.

The reorientation of production and trade towards Western Europe positions the accession economies well for further integration and also makes them generally less vulnerable to external shocks. Most observers agree that the more ambitious structural and institutional reforms pursued in these countries have been spurred on to no small extent by the external anchor that potential accession to the EU provides. As we see in the globalization process more generally, as countries attempt to integrate themselves into global financial, trade and economic networks, it helps to have relevant models for the institutional, legal and other reforms that are required. The EU has provided clear and well tested models in many areas for the accession countries.

By establishing a substantial number of policy goals and conditions on which consensus might be difficult to reach, an external anchor helps to focus policy, thereby functioning as an arbitration mechanism in case of differing internal political opinions. The European Union (EU) has played this role for the countries of central and eastern Europe and the Baltics, with EU accession providing an objective that continues to promote rapid structural and institutional reforms. Indeed, the lure of closer political and economic ties with western Europe was sufficiently powerful that it had an influence on policies in the EU accession group from the beginning of the transition process, well before they became formal candidates for membership in the Union.

An additional factor explaining the relatively good performance of the accession countries has been the spur provided both to privatization, and subsequently to investment, by foreign strategic investors. Their involvement is generally seen to have deepened the restructuring that took place, evident in the development of new products, markets, management techniques and business strategies-elements that were often missing in the privatization process in other transition economies. This, in turn, had a positive impact in increasing labor productivity, which has been particularly strong in Poland, Hungary, and Slovenia.

Despite this relatively positive picture, there are areas where progress is lagging. There are also uncertainties regarding the impact of accession on certain sectors. These uncertainties, in particular, pose questions for the accession countries, as well as for the current members of the EU. Let me touch briefly on four areas: the financial sector; the fiscal implications of integration; labor markets; and agriculture.

First, the financial sector. This stands at the cross roads of the macroeconomy-a strong financial sector can support sustainable economic growth; a weak financial sector can derail it. We have seen this repeatedly in an unfortunately large number of countries over the last decade. This latter risk is especially important in the run up to EU accession, and, later, to monetary union- because these are periods that could invite sizable and potentially volatile capital flows. If we have learned anything from the crises of the last 20 years, and especially from the Asian Crisis, it is that integration with regional and global markets - doubtless beneficial in the long term - puts substantial demands on the domestic financial system.

Managing increasing capital flows while liberalizing the capital account is always a challenge. Capital controls have been progressively eased in most accession economies. Those that remain will have to be removed on accession, in the absence of derogations. All accession countries have accepted the obligations of Article VIII of the IMF's Articles of Agreement and have removed most restrictions on transactions related to foreign direct investment.

Most accession countries still face large current account deficits. While foreign direct investment has to date accounted for a large share of the capital flows needed to cover these deficits, further liberalization of capital transactions will be necessary and desirable. However, this presents challenges to associated macroeconomic policies and the development of supporting institutions, including in regulation, supervision, and risk management-all areas where many recent crisis countries were found wanting. The lessons from these crises suggest that it is desirable to liberalize long term flows first, and most short term flows only later. The crises also underlined the importance of adopting full transparency in policies, data and accession prospects to avoid springing surprises on financial markets.

Within the financial sector, the picture presented by the banking sectors of the EU accession countries is a mixed one:

· While credit to the private sector has been increasing as a share of bank assets, it remains below the benchmark for most advanced economies. In some of the accession countries, state enterprises still enjoy financing at more favorable terms due to implicit or explicit government guarantees. We have seen in all too many countries that state direction of credit can be a recipe for trouble;
· Interest margins higher than the EU average suggests that there is room for further improvement in the efficiency of financial intermediation;
· At the same time, competition appears to have strengthened; the role of foreign strategic investors has increased to the point where they control the majority of banking sector assets; and the restructuring demanded by the large share of nonperforming loans and persistent negative returns is well under way in many of the accession countries.

In summary, the financial sectors of the accession economies are in much better shape than they were, but further strengthening is needed. Given the experience of other economies integrating into global financial networks, this would be true even if they were not embarked on possible EU entry.

Now let me turn briefly to the fiscal implications of integration. Necessary institution building, including in the financial sector and legal adjustments, will continue to impose a large fiscal burden. Beyond this, modernizing agriculture and mining, providing for massive infrastructure needs, and dealing effectively with the legacy of the poor environmental policies of the past will all be very costly. Indeed, environmental upgrading may well turn out to be the most costly area of compliance with EU standards.

These costs are not unique to the accession countries. They are faced by many other economies integrating into the global system and should be regarded not so much as a cost of accession per se but rather as fees that all countries have to pay as part of good citizenship in the modern world economy. Environmental upgrading to meet EU standards may be one example where the demands of accession per se are greater than that of globalization alone. The fees will therefore be higher in this case for the accession economies, but with a corresponding payoff in terms of higher quality of life and more sustainable development.

Offsetting these costs, accession countries will likely derive some fiscal savings, for example from reduced debt servicing costs, especially as they move closer to membership of the euro area. This was certainly the case for some current EU members after their accession. Other necessary changes will have uncertain fiscal impacts, including reforms to pensions and social benefit arrangements. Thus, it is impossible to predict precisely the net fiscal burden from accession.

Any calculation is further complicated by uncertainty regarding the contribution to these costs that can be expected-both pre and post accession-from the EU itself. It is also possible that some of these costs, for example for environmental improvements, will be borne by the private sector, such as the polluting companies themselves. Some loan support for such efforts is also available from the EIB and the EBRD.

Whatever the predicted bottom line, the fiscal risks and uncertainties facing the accession countries argue strongly for reaching and maintaining conservative fiscal positions. Almost all the accession countries have high public expenditure ratios. For some, fiscal weakness and heavy debt burdens imply that the candidate countries generally have little scope to fully accommodate accession-related spending or other fiscal risks. Reductions in other areas of spending could therefore be needed. Moreover, the accession countries need to retain substantial fiscal flexibility to help them manage the shocks to which they are likely to be subject as small open economies, notably large and potentially volatile capital flows. The prospect of EMU membership in the longer term makes the need for such flexibility all the greater.

I don't want to focus on EMU entry, as that is the subject of another session. But let me just observe in passing that there are a number of factors that should be taken into account in deciding how quickly to sign up to the single currency. First, there are the differences in the pace of structural reform from country to country. Second, there is the question of how quickly it is sensible to try to reduce inflation given the scale of relative price changes. And, third, there are differences in the maturity of financial sectors. It is important to remember that EMU entry will not in itself resolve the dilemma of volatile capital flows. The precise timing of entry should depend on the individual circumstances of the countries concerned and on progress in the factors I have just mentioned.

Now let me turn to the labor market and migration. With barriers to trade, foreign direct investment and other capital flows already largely removed within the EU, the guarantee that workers and their families can move across national borders to find work within an expanded EU could turn out to be the greatest additional contributor to economic integration arising from accession per se. Geographical proximity and substantial income differentials would together seem to create powerful incentives for people to move from accession countries to the rest of the EU.

It comes as no surprise then that the economic and social consequences of possible post-accession migration have caused heated debates in several countries. But tackling people's fears is made more difficult by the uncertainties that surround any projection of migration flows.

Experience from the southern enlargement of the EU to Greece, Portugal and Spain in the 1980s provides some clues. Around 3 percent of the citizens of these three countries now live elsewhere in the EU. However, the present stock of Med-3 citizens resident in other EU countries does not reflect the result of a quick build-up following accession and the introduction of the free movement of labor; in fact aggregate net migration flows for the Med-3 have been practically nil over the past decade, according to the Commission. Having said this, the aggregate data mask different patterns in national migration flows.

Analysis sponsored by the Commission, and based on survey estimates, econometric evidence, and historical experience, suggests tentatively that 3 per cent of the CEEC-10 population might migrate over the course of a 15 year period. In absolute numbers, this implies a peak outward flow of around 200,000 people after three to four years, gradually abating thereafter. These numbers are too small to imply much impact on jobs and wages across the EU as a whole. But - as with the southern enlargement (and perhaps even more so) - the pressures would be distributed unevenly. Migrants are likely to flow mainly to Germany and Austria, by virtue of their proximity. This suggests that the impact may be significant in some communities and also in particular trades there, perhaps construction and parts of the service sector.

In discussing the likely impact of accession on migration, it is important to distinguish between permanent migration and short-term "commuting". Long common borders and hefty income differentials across them suggest that the latter may be more important, although historical experience provides little guidance. Once again, this suggests that pressures would be concentrated in particular communities and particular trades, rather than widely spread.

In thinking about the labor market challenges that confront the EU as a result of accession, it is worth reflecting on the capacity that the US has demonstrated to absorb relatively large numbers of migrants. By 2000, some 10 percent of the US population were immigrants, up from 5 percent in 1970. As the US experience shows, absorbing immigrants is much easier and causes fewer social problems when you have a flexible and strongly growing economy. Consequently, the main lesson for the EU and the candidate countries is that accession further underlines what should already be obvious: that there is a need for further structural reforms to make labor and product markets more flexible. This will allow macroeconomic policy to accommodate stronger growth rates without running into unsustainable inflationary pressures. Safety nets and help with retraining and education will be important too in the areas most affected.

In the US, immigrants have tended to be younger than the native population. If this were to be true as well of migration from the accession countries to the rest of the EU, it would be a boon to the recipient countries in light of the strain that aging populations and the consequent rise in the dependency ratio will put on social welfare systems in those countries.

Finally, let me say a brief word about agriculture, which offers an important challenge in the accession context for a number of reasons. First, it is the sector where remaining trade barriers between the accession countries and the rest of the EU are highest. Second, the number of farm workers in Poland and Romania alone is larger than in the whole of the current EU. Third, the agriculture sector in these countries is characterized by low productivity and substantial hidden unemployment, implying a rich source of potential migrants. And fourth, agriculture is encompassed by a complex policy framework at both the EU and global levels, through the CAP and WTO rules.

Accession will remove remaining agricultural trade barriers between the EU and its new entrants, as well extending to those entrants the protections and subsidies available under the CAP. Following the completion of the Uruguay Round, subsidies to agricultural production and exports are constrained. Yet the CAP remains an important factor. Current EU members are concerned both by the prospect of fiercer competition from farm sectors with much lower labor costs, and by the implications for the EU budget of extending subsidies to new entrants, notwithstanding recent reductions in CAP subsidy rates for some protected commodities.

Over the longer term, we would clearly expect agricultural sectors to become smaller and more efficient in the accession countries as membership of the EU accelerates economic convergence and development. However, the CAP will slow rather than accelerate this process. This might have advantages in restraining migration pressures, but in the longer term it is in everyone's interest that market forces play a less impeded role in the agricultural sector. As with migration generally, the keys to smoothing the adjustment process are structural and macroeconomic policies geared to greater flexibility and stronger growth throughout the EU.

It is also the case, of course, that agricultural subsidies - in the US and other industrial countries, not just the EU - inflict real damage on agricultural producers in many of the world's poorest countries, and these producers are among the most vulnerable people in those societies. Reducing these subsidies would be an effective way to help tackle global poverty. The evidence is overwhelming that reduction of the trade barriers in this and other sectors, especially in the EU, would be the best way in which the developed world could help improve the prospects for the poorest countries to emerge out of their dire poverty. Such action would also help at home, benefiting consumers and strengthening public finances. Having said this, I appreciate the difficulties and tensions that change in this sector involves in all countries.

To conclude, let me observe once again that the spur of accession has already delivered important policy reforms and consequent improvements in economic performance. The completion of the process will doubtless deliver more of the same. But we should remember that accession is part of a bigger picture: globalization, which also acts as a spur to better policies and stronger performance. Europe's citizens, as well as those of the rest of the world, can potentially benefit enormously from these forces if they are properly managed and if they are made to operate in a complementary way.

Thank you.