Kari E.O. Alho*, Ville Kaitila** and Mika Widgrén***

Speed of Convergence and Relocation: New EU Member Countries Catching up

with the Old****

* ETLA and University of Helsinki** ETLA*** Turku School of Economics, ETLA, CEPR and CesIfo**** ETLA DP No. 963, ENEPRI WP No. 34

May 2005

Background and motivation

• Convergence of the new EU member countries (NMCs) is vital for the homogeneity of the EU– How fast and– How sustainable is the convergence process,

both in real and nominal terms?

• There are fears of relocation of production and jobs from the EU-15 to the NMCs

Aims to analyse

• The real and nominal convergence of the NMCs (ACCs) towards the EU-15:– Real income– Consumption– Price level– Wage level– Balassa-Samuelson framework with several extensions

• The impact of this process, through relocation, on the EU-15:– In terms of GDP– National income– Aggregate growth model

Figure 1 Real convergence: GDP per capita (PPP) in the NMCs, EU-15 = 100

0

10

20

30

40

50

60

70

80

1992 1994 1996 1998 2000 2002 2004* 2006*

Czech Republic Estonia HungaryLatvia Lithuania PolandSlovak Republic Slovenia NMC8

Source: European Commission

Figure 2. Nominal convergence: Price level(ratio of current exchange rate to PPP exchange rate) in the NMCs, EU-15 = 100

0

10

20

30

40

50

60

70

80

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Czech Republic Estonia HungaryLatvia Lithuania PolandSlovak Republic Slovenia NMC8

Source: International Monetary Fund, World Economic Outlook Database

Building a dynamic CGE model for convergence

• A model for the new member countries (NMC)– Two sectors, open and sheltered– Introduction of the basic message from empirical convergence literature: growth

rate decelerates as convergence proceeds, see below– Capital accumulation in the open sector through partial adjustment– A combination of forward-looking and liquidity-constrained consumption

behaviour– International labour mobility based on existing gap in real wages– Inflow of FDI has a spillover effect on domestic TFP, endogenous growth

• A model for EU-15– Outflow of capital through FDI flows into the NMCs, motivated by outsourcing of

production to low cost NMCs– Utilisation of this gain in competitiveness in EU-15 production– Budgetary transfers between the EU-15 and NMCs through the EU budget

• Both regions are open to the world economy, the convergence process does not have an influence on the global prices or interest rates

Combining the basic message of convergence to the model:

tt

t

Qg

Q1

0 1 *1

log

Let us fix the long-run equilibrium: at time T QT = QT* and gT = gT*

This calibrates the parameters β0 and β1, given the initial growth rate g and g*, and the initial ratio of income levels.

Let productivity growth in the open sector be 6% and the sheltered sector be 4.5% p.a.

The basic Balassa-Samuelson framework combined with beta convergence

0

10

20

30

40

50

60

70

80

90

100

2000 2005 2010 2015 2020 2025 2030

Income level

Price level

Wage level

Combining uncertainty with the basic B-S framework

2 2 21 1 *( ) (1 ) ( )rel rel

t t gV q V q

0

10

20

30

40

50

60

70

80

90

100

2000 2005 2010 2015 2020 2025 2030

baseline 50% 95%

Specification of a CGE model

• Endogenous growth in NMCs: TFP growth in the NMCs is a function of FDI inflows

* 1, 1 1 1 1 0 0

111 * log / 1 t

Tt T t t t Ttt

Kfdi KfdiKfdiA A g q q a g

K Kfdi

The human capital/income in NMCs and relative income in NMCs in ratio to EU-15

15

20

25

30

35

40

45

2000 2005 2010 2015 2020 2025 2030

0.4

0.5

0.6

0.7

0.8

0.9

1

human capital/income, leftscale

relative income, right scale

Aggregate consumption: sum of that of liquidity (income) constrained and forward-looking consumers

The model for EU-15

1* *1

Q Y *M Qwhere

Outsourcing improves the profitability of EU production

*1

** , / *1Y

PPP P where Kfdi K

So technology is in this sense endogenous. The FDI is determined through a portfoliobalance equation,

0/ * ( ( ( * / *))NMCKfdiopt K s r d p p

Actual Kfdi follows then through partial adjustment

Q* = gross prodY* = value addedM = imported intermed. goods

Two scenarios

• Baseline: no further FDI inflows from the EU-15 into the NMCs

• Alternative scenario 1, vigorous FDI inflows so that the stock of FDI of the EU-15 firms in the NMCs grows six-fold in 30 years.

• Time span: 2000-2030

• Forward-looking consumption behaviour for a part of the NMC consumers

Growth rate in the NMCs in the two scenarios

.03

.04

.05

.06

.07

2000 2005 2010 2015 2020 2025 2030

G (Baseline) G (Scenario 1)

The inflation rate

.028

.032

.036

.040

.044

.048

.052

2000 2005 2010 2015 2020 2025 2030

INFL (Baseline) INFL (Scenario 1)

The rate of rise of the wage rate, per cent

7

8

9

10

11

12

2000 2005 2010 2015 2020 2025 2030

WAGEG0 WAGEG1

The total labour force (Lacc), labour in the open (L open) and sheltered (Lshel) sectors in NMCs in the high FDI scenario

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

2000 2005 2010 2015 2020 2025 2030

LACC (Scenario 1)LOPEN (Scenario 1)LSHEL (Scenario 1)

Impact on welfare, consumption in scenario 1 / baseline

0.988

0.992

0.996

1.000

1.004

1.008

1.012

1.016

1.020

1.024

2000 2005 2010 2015 2020 2025 2030

CONSDIFF

Foreign debt in NMCs in relation to GDP

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

2000 2005 2010 2015 2020 2025 2030

DREL (Baseline) DREL (Scenario 1)

0.0

0.4

0.8

1.2

1.6

2.0

2.4

2000 2005 2010 2015 2020 2025 2030

DREL (Scenario 1)

Foreign debt /GDP, with share h of forward-looking consumers being 50%

Rate of return in NMCs in the baseline scenarioand the high FDI inflow scenario 1

.165

.170

.175

.180

.185

.190

.195

2000 2005 2010 2015 2020 2025 2030

RHO (Baseline) RHO (Scenario 1)

Real and nominal convergence in the high FDI scenario, NMCs / EU-15

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

2000 2005 2010 2015 2020 2025 2030

PREL (Scenario 1)QREL (Scenario 1)WREL (Scenario 1)

GDP, the real wage, National Income and Income ofincumbent EU-15 nationals, endogenous FDI (scenario 1)in relation to baseline of fixed stock of inward FDI

0.994

0.996

0.998

1.000

1.002

1.004

1.006

1.008

2000 2005 2010 2015 2020 2025 2030

QEUDIFFQEUNATINCDIFF

WEURDIFFYINCUMBDIFF

-.6

-.4

-.2

.0

.2

.4

2000 2005 2010 2015 2020 2025 2030

DLOGQDLOGK

DKFDIDLOGL

Decomposition of difference, %, in EU-15 GDP between the scenarios

Policy questions raised by the model

• Inflation in NMCs seems to be quite a persistent problem, average 4% p.a.?

• Foreign indebtedness a looming problem if a vigorous growth continues?

• Outsourcing not a problem for the EU-15 in a GE sense? Of course, this depends on the magnitude of the shock, but it was in the simulation quite sizeable in itself.

• There is a polarising outcome with respect to further integration in the EU-15.