9781589065543

O C C A S I O N A L PA P E R
252
Growth in the Central and Eastern

European Countries of the European Union
Susan Schadler, Ashoka Mody, Abdul Abiad, and Daniel Leigh
INTERNATIONAL MONETARY FUND

Washing ton DC
20 06
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Growth in the Central and Eastern European countries of the European
Union/Susan Schadler . . . [et al.]—Washington, D.C.: International Mon-
etary Fund, 2006.
p. cm.—(Occasional papers; 252)
Includes bibliographical references.
ISBN-13: 978-1-58906-554-3
ISBN-10: 1-58906-554-9
1. Europe, Central—Economic conditions. 2. Europe, Eastern—Economic
conditions. 3. Europe, Central—Economic policy. 4. Europe, Eastern—
Economic policy. 5. International Monetary Fund. I. Schadler, Susan.
II. International Monetary Fund. III. Series: Occasional paper (International
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Contents
Preface vii
Abbreviations viii
I Overview 1
II Scope of the Study 4
III The Record: Enduring Strengths or a Bounce Back? 6
IV Growth Scenarios: Possible Paths for the Catch-Up 14
V Policies and Long-Term Growth: What Can Be Learned from

Other Countries? 18
Lessons from Large Sample Studies of Long-Term Growth 18
Updated Estimates of Growth Determinants 20
Interpreting the Strengths and Weaknesses of the CEECs 23
Trends and Prospects 24
VI European Integration: Opportunities for Growth 27
VII Implications for IMF Surveillance 35

Labor Absorption 35
Closing the Productivity Gap 35
Use of Foreign Savings 37
Euro Adoption 37
Appendix. Growth Regressions and Data Description 39
References 51
Concluding Remarks by the Acting Chair, Executive Board

Seminar, February 27, 2006 53
Boxes
3.1. Compositional Shifts in Output: Implications for Productivity Growth 10
5.1. Measuring Institutional Quality in the CEECs 22
6.1. International Financial Linkages and Growth 28
Figures
2.1. Macroeconomic Trends in the CEECs, 1990–2004 5
3.1. Emerging Market Economies: Growth in Real PPP GDP Per
Capita, 1990–2004 7
iii

CONTENTS
3.2. CEECs and Other Emerging Market Regions: Growth in Real

Per Capita GDP 8
3.3. Employment Rates in the CEECs 8
3.4. Contributions to Average GDP Growth 9
3.5. Employment and Activity Rates in Emerging Market Economies, 2004 12
3.6. Investment and Growth in Emerging Market Economies, 2000–04 12
3.7. Savings and Investment Rates in Emerging Market Economies, 2004 13
5.1. Global Sample: Institutional Quality and the Speed of Convergence 21
5.2. Emerging Market Economies: Actual and Predicted Per Capita GDP
Growth, 2000–04 23
5.3. CEECs: Actual and Predicted Per Capita GDP Growth, 2000–04 23
5.4. Per Capita GDP Growth in the CE-5 and Baltic Countries Relative
to Other Emerging Market Regions, 2000–04 24
5.5. CEECs: Predicted Per Capita GDP Growth, 2005–09 26
6.1. European Union: Current Account Deficits and the Speed of
Convergence, 1960–2004 29
6.2. CEECs: FDI and Non-FDI Financing of Current Account Deficit 30
6.3. CEECs: Predicted Versus Actual Per Capita GDP Growth 31
6.4. CEECs: Actual Versus Predicted Current Account Balance 32
6.5. CEECs in 2005 and East Asia in 1996: Selected Vulnerability
Indicators 33
6.6. The CEECs and East Asia: Selected Governance Indicators 34
7.1. Fiscal Balance and Risk Ratings in Emerging Market Economies,
1990–2002 36
7.2. CEECs: Foreign Currency Government Bond Spreads 37
A1. Emerging Market Countries: Actual and Predicted Per Capita GDP
Growth, 2000–04 43
A2. CEECs: Actual and Predicted Per Capita Growth, 2000–04 43
A3. Current Account Balances and GDP Growth in the European
Union, 2000–04 48
Tables
4.1. CEECs: Convergence with Euro Area Income Per Capita 15
4.2. Decomposing the Income Gap Between the Euro Area and the CEECs 15
4.3. Scenario 1: Speeding Up Convergence in the CEECs Through
Higher Investment 16
4.4. Scenario 2: Speeding Up Convergence in the CEECs Through
Higher Productivity Growth 16
5.1. Growth Regression Estimates 21
5.2. Evolution of Growth Determinants in the CEECs, 1989–2004 25
A1. Global Sample of Economies 40
A2. Growth Regressions with Core Controls, Using Different
Country Samples 41
A3. Growth Regression Estimates 41
A4. Growth Accounting Regressions 42
A5. CE-5: Decomposition of Growth Differences 45
A6. Baltic Countries: Decomposition of Growth Differences 46
A7. Growth and Current Account Deficit Regressions 49
A8. Emerging Market Economies 50
iv

Contents
The following conventions are used in this publication:
• In tables, a blank cell indicates “not applicable,” ellipsis points ( . . . ) indicate “not avail-
able,” and 0 or 0.0 indicates “zero” or “negligible.” Minor discrepancies between sums of
constituent figures and totals are due to rounding.
• An en dash (–) between years or months (for example, 2005–06 or January–June) indicates
the years or months covered, including the beginning and ending years or months; a slash
or virgule (/) between years or months (for example, 2005/06) indicates a fiscal or finan-
cial year, as does the abbreviation FY (for example, FY2006).
• “Billion” means a thousand million; “trillion” means a thousand billion.
• “Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are
equivalent to of 1 percentage point).
As used in this publication, the term “country” does not in all cases refer to a territorial
entity that is a state as understood by international law and practice. As used here, the term
also covers some territorial entities that are not states but for which statistical data are main-
tained on a separate and independent basis.

This page intentionally left blank

Preface
Having smoothly acceded to the European Union (EU) in May 2004, the overarch-
ing objective for the EU’s new member states is to continue raising living standards to
Western European levels. This Occasional Paper examines the progress toward income
convergence achieved by the the EU’s eight Central and Eastern European countries thus
far, the prospects for further income convergence over the medium term, and the policy
challenges that these countries will face in facilitating the catch-up process.
The paper was prepared by a team led by Susan Schadler and Ashoka Mody, with Abdul
Abiad and Daniel Leigh. The paper benefited from comments by various departments of
the IMF; by participants at a September 2005 conference on “European Enlargement:
Implications for Growth” in Washington, D.C., and at a March 2006 conference on “New
Europe, New Frontiers, New Challenges, New Opportunities” in Prague; and by partici-
pants at seminar presentations in Tallinn and Warsaw and at the IMF’s European Depart-
ment. Material presented in this study was originally prepared as background for an IMF
Executive Board seminar held in February 2006. The Acting Chair’s concluding remarks
are reproduced on pages 53–54 of this publication.
The authors would like to thank Indra Mahadewa, Lina Shoobridge, Sylvia Young,
and Indira Bhimani for assistance in preparing the manuscript; David Velazquez-Romero
for excellent research assistance; and Esha Ray of the External Relations Department
for editing the manuscript and coordinating production of the publication. The opinions
expressed in the paper are those of the authors and do not necessarily reflect the views of
national authorities, the IMF, or IMF Executive Directors.
vii

Abbreviations
CE-5 Refers to Czech Republic, Hungary, Poland, Slovakia, and Slovenia

CEEC Central and Eastern European country
EBRD European Bank for Reconstruction and Development
EU European Union
FDI Foreign direct investment
GDP Gross domestic product
GFS Government Finance Statistics
ICRG International Country Risk Guide
ICT Information and communication technology
OECD Organization for Economic Cooperation and Development
PPP Purchasing power parity
PWT Penn World Tables
TFP Total factor productivity
WDI World Development Indicators
WEO World Economic Outlook
viii

I Overview
he paramount economic objective of the Central • Massive labor shedding occurred alongside rela-
T and Eastern European countries (CEECs) is to
raise living standards to Western European levels.1
tively rapid output growth. Employment rates
dropped from among the highest in emerging mar-
After a half century of largely misdirected develop- ket countries at the end of central planning to well
ment, the task is formidable and will require concerted below average.
macroeconomic and structural policies focused on
• Relatively low domestic savings rates were supple-
achieving strong growth with due regard for vulnerabil-
mented by foreign savings, particularly in the three
ities inherent in any rapid catch-up. In many respects,
Baltic countries.
this process resembles that in other regions, and the
CEECs will be well advised to draw lessons from expe- • Nevertheless, capital accumulation made modest
riences elsewhere. But, in other respects—particularly contributions to growth—on average smaller than
the advantages of membership in the European Union in the most dynamic Asian countries, though larger
(EU)—the CEECs have unique opportunities from than in Latin America.
trade-induced competition, pressures for policy reform, • Growth was dominated by remarkable increases
and greater financial integration. in total factor productivity (TFP). TFP growth
The strength of the growth record in the CEECs since was almost double that in other emerging market
the end of central planning is open to interpretation. country groups. This is not surprising in view of
From a 15-year perspective—that is, including the ini- the inefficiencies inherited from central planning,
tial transition shock—the record is no better than aver- which left much scope for managerial improve-
age by the standards of emerging market countries. In ments, labor shedding, and gains from interindustry
the past decade, however, growth in most of the CEECs resource reallocation.
has been clearly above the average of emerging market
countries; in fact, the three Baltic countries (Estonia, • The recent record, however, suggests the possibility
Latvia, and Lithuania) have been in the top five emerg- of a two-speed catch-up: growth in the three Baltic
ing market performers. Evaluating the performance of countries having pulled substantially ahead of that
the CEECs is complicated by three developments that in the five Central European countries (the Czech
are difficult to disentangle: a recovery from the imme- Republic, Hungary, Poland, Slovakia, and Slovenia;
diate post-central-planning drop in output; the emer- henceforth, CE-5).
gence of policies and institutional conditions (including Looking ahead, the critical question is whether
EU membership) that enhanced catch-up potential; and TFP growth can be sustained, and, if not, what would
global economic developments favorable to investment replace it as the underpinning of a rapid catch-up. Dif-
and growth in emerging market countries. Thus, deter- fering time lines of transition may shed light on this
mining whether the strength of the past decade has question. On average, countries that recovered earliest
been more a bounce back from the initial posttransition from the transition shock—broadly the CE-5, but espe-
setbacks in a period relatively favorable for emerging cially Poland and Slovenia—have seen a substantial
market countries or more the result of conditions that diminution in TFP growth (though it remains higher
will support continuing growth requires an examina- than in other emerging market country groups). This
tion of the underlying influences. is broadly reflected in lower output growth, although
In several respects, the CEECs’ growth experience a halt or slowing in labor shedding has been a mitigat-
during the past decade was unusual by emerging mar- ing influence. In contrast, TFP growth in the later-to-
ket country standards. recover Baltics has continued to rise. Assuming that the
slowdown in TFP continues in the CE-5 and spreads to
1The CEECs comprise the Czech Republic, Estonia, Hungary, the Baltic countries, other sources of growth will be
Latvia, Lithuania, Poland, the Slovak Republic (henceforth, Slova- essential to sustain a rapid catch-up. Greater labor use
kia), and Slovenia. is an obvious candidate: to live up to its growth poten-

I OVERVIEW
tial, every country—particularly Poland, Hungary, and Baltics come a close second. Years of schooling are
Slovakia—must decisively turn around its labor market highest on average in East Asia, but more complex
performance. Also, investment rates will need to rise. educational considerations, which are undoubtedly
Finally, financing will be the major challenge in these important, may stack up differently. Relative prices
generally low-saving countries. of investment goods are broadly similar.
Whatever the source of growth, prospects will depend Moreover, European integration stands to play a piv-
on how well countries do in establishing macroeconomic otal role in supporting a rapid catch-up in the CEECs.
and structural conditions conducive to sustained growth. At one level, of course, are the opportunities offered
Building on global studies of links between growth and by substantial EU transfers—likely to be some 2–3
a variety of environmental and policy characteristics, percent of GDP a year for some time. Probably more
some broad conclusions emerge on the conditions for a important but less easy to quantify will be the benefits
rapid catch-up. Robust linkages come from certain envi- from closer institutional, trade, and financial integra-
ronmental features (such as initial income gaps, population with Western Europe. These are already evident
tion growth, and historical trade relationships), as well in growing trade volumes, low risk premia, and rising
as conditions more subject to policy influence (such as use of foreign savings in the CEECs; further changes in
the quality of legal and economic institutions, size of these directions are likely, especially for countries that
government, real cost of investment, educational attain- commit to early euro adoption. But alongside the scope
ment, openness to trade, and inflation). In general, the for hastening the catch-up are the risks that foreign
CEECs do reasonably well in meeting these conditions savings will finance insufficiently productive spending
(relative, for example, to an East Asian sample2). On or that the consumption smoothing turns into excessive
average, however, the differences tend to favor growth
private or government spending.
in the Baltic countries over the CE-5, reinforcing other
Estimates of a simple growth and current account
indications that a two-speed catch-up may be emerging.
framework, using European data, provide some comfort
Some broad conclusions stand out.
in this regard. They indicate that thus far foreign sav-
• Initial income gaps vis-à-vis advanced econo- ings have contributed significantly and appropriately
mies—reflecting catch-up potentials—were gener- to growth in most CEECs. Most, even with large cur-
ally smaller in the CEECs than in East Asia, though rent account deficits, have growth rates within ranges
in three countries (Poland, Latvia, and Lithuania) that should result (according to the experience of the
the gaps were larger than the East Asian average countries included in the sample) from the foreign sav-
even as of 2004. ings used. Moreover, distinctions between the effects of
foreign direct investment (FDI) and non-FDI financing
• Slow population growth has favored catch-up
are not large—both have contributed significantly to
in the CEECs (especially the Baltics) over East
growth. In other words, to the extent that integration is
Asia, although, over time, aging could shift this
facilitating increased use of foreign savings even when
advantage.
it is not FDI, it appears to be giving CEECs a growth
• The Baltics and East Asia have benefited decisively advantage over other emerging market countries. Varia-
relative to the CE-5 from faster growth in their tions across countries are, however, large—from Esto-
historical export markets—Baltic exports are more nia, where current account deficits exceed the range
oriented toward the Nordic countries and Russia indicated as consistent with recent growth rates, to
and CE-5 exports more toward Germany and its Poland, where they fall short of that range.
immediate neighbors. Nevertheless, some measures of vulnerabilities, espe-
• The CE-5 have had the edge on institutional devel- cially in the Baltic countries and Hungary, are worri-
opment (regulatory frameworks and governance) some. Various combinations of high external debt ratios,
relative to East Asia and even the Baltics, though rapid credit growth (a sizable share in foreign currency),
the latter have been catching up rapidly. and, in the Baltics, low reserve coverage of short-term
debt create a picture similar, for some countries, to that
• On other policy variables, the CEECs have had in East Asia prior to 1997. Some mitigating factors—
differing strengths, which taken together have had high reserves in the CE-5, strong fiscal positions in the
roughly comparable effects on growth. All coun- Baltics, relatively high standards of transparency and
tries are highly open to trade. East Asian countries governance, well-supervised and predominantly foreign-
on average have smaller governments, although the owned banks—are reassuring. While a full analysis of
vulnerabilities is beyond the scope of this paper, even
the summary picture of vulnerability indicators points
2The East Asian economies considered are China, Hong Kong to challenges for IMF surveillance.
SAR, Indonesia, Korea, Malaysia, the Philippines, Singapore, Tai- Rapid income convergence will be the essential con-
wan Province of China, and Thailand. text of IMF surveillance in the CEECs for the foresee-

Overview
able future. Sound near-term macroeconomic policies porate governance and efficient bankruptcy procedures;
are needed to foster a benign setting for growth. Equally and increase transparency across the spectrum of eco-
important will be identifying and supporting conditions nomic activities. The IMF also needs to be an advocate
that spur growth and position countries to benefit from of policies that will enable the early adoption of the
European integration; some of these, such as institu- euro—the growth-enhancing and vulnerability-reducing
tional development and the appropriate role of govern- opportunity unique to the CEECs.
ment, will be at one remove from the traditional focus But, fundamentally, rapid catch-up will be associated
of surveillance. Nevertheless, they are critical to out- with vulnerabilities. The use of foreign savings entails
comes for growth, and, all told, sustaining high growth exposure to foreign creditors and investors; in countries
is the ultimate economic objective for each CEEC. that started with minimal banking systems, rapid credit
Within this context, a key role for surveillance will be growth is almost inevitable, and where households had
to keep a sharp eye on vulnerabilities. A rapid catch-up little or no access to credit, growing confidence in the
inherently involves risks, whether from the large-scale future means sizable borrowing to smooth consump-
use of foreign savings, the rapid growth in financial mar- tion. The macroeconomic picture of any successful
kets and bank intermediation, or simply the rapid pace CEEC will not be free from risks. The task for surveil-
of economic change. Certainly, policies to mitigate these lance will be to distinguish when policies with an over-
risks and make them more transparent are critical. In arching orientation of supporting a rapid catch-up are
this vein, the IMF needs to press governments to estab- and are not appropriate, identify policy changes that are
lish cushions against shocks; contribute to domestic sav- needed, and recognize that some developments, which
ings appropriately through sizable fiscal surpluses when in more advanced or less opportunity-laden countries
catch-ups are rapid; avoid disincentives to private saving; would indicate serious vulnerabilities, are an inescap-
support strong financial supervision; ensure strong cor- able part of the catching-up process.

II Scope of the Study
n the past 15 years, the IMF’s dialogue with the eight that in the CE-5 in the past five years. Of course, differ-
I new CEEC members of the EU has been about tran-
sitions.3 The first transition was from central planning
ences exist within these two groups—Slovakia’s recent
gains relative to the other CE-5 countries being an
to market-oriented policies and the next from being important example. But if the pattern persists, it could
neighbors to being members of the EU. The accom- affect investors’ actions and become self-reinforcing.
plishments have been significant: after regaining pre- The slower-growing countries will therefore need to rise
transition GDP and stabilization, the countries have to the challenge of regional competition.
become attractive destinations for international capital The emergence of some signs of vulnerabilities is
(Figure 2.1). The efforts behind these successes gave inherent in any rapid catch-up, especially one involv-
substance first to the IMF’s lending arrangements ing large-scale use of foreign savings. Although a full
and, more recently, to surveillance. assessment of vulnerabilities is beyond the scope of
The central challenge now—to catch up to advanced this paper, it attempts to put these signs into perspec-
EU income levels—is matched by unique opportunities. tive. The analysis points to the consonance in some
The focus of policies is to create the basis for strong countries between more rapid growth and large-scale
growth, while avoiding disruptive breaks in progress or use of foreign savings. Nevertheless, a clear challenge
conditions that would produce costly misallocations of for surveillance will be to ensure that catch-up does not
resources. EU membership should make these efforts generate excessive vulnerabilities.
easier. Growing financial integration into Europe has The paper is organized as follows. Section III records
enhanced each country’s ability to draw on foreign sav- the region’s growth performance, using other emerg-
ings; the adoption of the euro promises to eliminate ing market countries as comparators and a growth-
currency risk premia and boost trade; and with growth- accounting framework to identify the sources of growth.
oriented policies these opportunities should hasten the Section IV outlines two growth scenarios that illus-
catch-up. trate the range of investment and productivity growth
A two-speed catch-up—rapid in the Baltics and slower rates under an ambitious income catch-up objective.
in the Central European countries—is, however, emerg- Section V draws on the extensive literature on empiri-
ing as a distinct possibility. Although average growth cal growth equations and uses updated cross-country
since transition is broadly similar across the eight coun- growth analyses to identify strengths and weaknesses
tries, growth in the three Baltic countries has surpassed in the region. Section VI focuses on one aspect of inte-
gration with Europe: the opportunity to supplement
3Because of the commonality of regional issues, the focus is on
domestic savings with foreign savings intermediated
the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, through European financial markets. Section VII con-
Slovakia, and Slovenia. cludes with implications for IMF surveillance.

Scope of the Study
Figure 2.1. Macroeconomic Trends in the CEECs, 1990–2004
1990–94 1995–99 2000–04
Growth in Real Per Capita GDP Inflation

(Annual average, in percent) (Annual average, in percent)
153 192 288 243 226
10 50
5 40
0 30
–5 20
–10 10
–15 0
ep.
Estonia
Latvia
ep.
Slovakia
Slovenia
Poland
ia
Estonia
Latvia
y
Slovakia
Slovenia
Poland
ia
y
Hungar
Hungar
Lithuan
Lithuan
Czech R
Czech R
Private Capital Flows (Net) Direct Investment (Net)

(Annual average, in percent of GDP) (Annual average, in percent of GDP)
20 10
15 8
10
6
5
4
0
–5 2
–10 0
ep.
Estonia
ep.
Latvia
Slovakia
Slovenia
Poland
Estonia
ia
Latvia
Slovakia
y
Slovenia
Poland
ia
y
Hungar
Hungar
Lithuan
Lithuan
Czech R
Czech R
Sources: Penn World Tables; and IMF, World Economic Outlook.

III The Record: Enduring Strengths
or a Bounce Back?
rom one perspective, focusing on the past decade, A distinctive characteristic of the CEECs’ perfor-
F growth in the CEECs has been impressive. Fol-
lowing sharp output losses in the initial transition
mance since 1995 has been small, or even negative,
contributions of labor input.6 Employment rates (per-
period, the CEECs have been among the stronger persons employed as a share of working-age population)
forming emerging market countries. During 1990–94, fell sharply during much of the 1990s (Figure 3.3),
when the costs of transition from central planning reflecting a variety of transition effects. State-owned
were largest, per capita GDP fell in each of the CEECs enterprises were downsized or privatized; permanent
(Figure 3.1).4 But as significant policy reforms and unearned incomes (through preretirement benefits and
institutional developments paid dividends, recoveries disability pensions) weakened job-search incentives
were generally rapid (Figure 3.2).5 Between 1995 and and discouraged retraining for the new market econ-
1999, even with the Russian shock, all but Lithuania omy; and barriers to regional labor mobility and other
and the Czech Republic were squarely in the top half labor market rigidities further contributed to long-term
of emerging market growth performers. Since 2000, structural unemployment (Keane and Prasad, 2000;
the Baltic countries have pulled rapidly ahead of the Estevão, 2003; Schiff and others, 2006; and Choueiri,
CE-5, placing them among the top five emerging 2005). In this respect, the CEECs stand out among
market performers in terms of growth. Nevertheless, emerging market countries, where labor input has typi-
CE-5 growth rates were still in the top half of emerg- cally contributed substantially to growth (Figure 3.4).
ing market countries. Although labor use has now stabilized, employment
But the broad sweep of developments since 1990 rates are still below the average for emerging market
raises a concern. From this perspective, only Poland countries, except in the Czech Republic, Estonia, and
and Estonia come out in the top half of emerging mar- Latvia (Figure 3.5).
ket country performers, and even they are well below Capital has provided a substantial contribution to
the fastest-growing countries. This record then begs the growth (see Figure 3.4). On average, the contribution
question of whether the relatively strong performance of capital accumulation to growth has been lower than
since 1995 owes more to a bounce back from the sharp, in East Asia or in the top emerging market country
early-transition losses, particularly in the Baltics, than performers, but greater than in Latin America. Within
to enduring strengths. Similarly, does the gap between the CEECs, however, the range of investment rates has
recent growth in the Baltics and in the CE-5 reflect fun- been large and in some cases relationships to growth
damental differences in policies and growth potential, have been among emerging market outliers (Figure
or simply the reversal from their later and larger early- 3.6). At one extreme, the Czech Republic has had par-
transition drop and sharper fallout from the Russian ticularly strong investment; its relatively slow output
crisis? It will be several years before answers to these growth suggests either low efficiency of investment and
questions are clear. In the meantime, the continuation high amortization rates or long lags in the coming to
of relatively rapid recent growth cannot be treated as fruition of investment. At the other extreme, the Baltics
a given. managed rapid growth in the past few years with mod-
erate investment rates.
A key question is whether relatively low savings
4Emerging market countries are a group of 37 middle- and low-
rates are holding back investment. Savings rates in
income countries that have significant interactions with world capi-
tal markets. They comprise countries in the Morgan Stanley Capital the CEECs are generally low, with only the Czech
International Emerging Markets Index, the CEECs, Bulgaria, and Republic and Slovenia firmly in the upper half
Romania. For the analytical usefulness of the emerging market cat- and Slovakia in the center of the emerging market
egorization, see Rogoff and others (2004).
5Fischer, Sahay, and Végh (1996); Havrylyshyn and van Rooden
(2000); Campos and Coricelli (2002); and EBRD (2004) establish 6This conclusion stands even when account is taken of hours
the effect of stabilization policies and institutional development on worked; average weekly hours worked in the CEECs have been
the speed of recovery from initial output losses. stable or have declined slightly in the past decade.

–15
–10
–5
0
5
10
–15
–10
–5
0
5
10
–15
–10
–5
0
5
10
–15
–10
–5
0
5
10
1
China India China China
Latvia China Thailand Korea
Estonia Poland Lebanon
Argentina
Russia Croatia
Estonia Korea
Lithuania Thailand
Singapore Malaysia
Bulgaria Chile
Slovakia
Romania Indonesia
Slovenia India
Korea Chile Malaysia
Chile
Thailand Hong Kong SAR Singapore
(Average annual percent change)
Latvia
Hungary Singapore Indonesia
Per Capita, 1990–20041
Lebanon
India Sri Lanka Sri Lanka
Korea
Slovakia Hong Kong SAR
Malaysia Israel
Croatia Poland
Hungary Egypt
Hong Kong SAR Egypt
Egypt India
Slovenia Argentina
Philippines Colombia
Poland Estonia
Turkey
Baltic countries
Indonesia Peru Turkey

Czech Rep. Peru
Morocco Peru
Sri Lanka Lithuania
Turkey Pakistan
Czech Rep.
2000–04
1995–99
1990–94
Malaysia Mexico Hungary

1990–2004
Chile Jordan
Pakistan Slovenia
Sri Lanka
CE-5
Pakistan Israel
Israel Venezuela
Philippines Philippines
Morocco Pakistan Brazil
Mexico
Singapore Argentina Jordan
Morocco
Lebanon Brazil Philippines Slovakia
Mexico Mexico Poland Colombia
Others
Peru Thailand South Africa Russia

Egypt South Africa Jordan
Czech Rep.
Sources: Penn World Tables (PWT); IMF, World Economic Outlook; and IMF staff calculations.
Turkey Colombia Brazil
Hungary
Brazil Indonesia Czech Rep.
Slovenia
Jordan Morocco Lithuania
South Africa Romania Romania
Latvia
Slovakia
growth rates are available only from 1991 for Lebanon, 1992 for Bulgaria and Russia, and 1996 for Croatia.
Colombia Hong Kong SAR Romania
Figure 3.1. Emerging Market Economies: Growth in Real PPP GDP

Israel Russia Estonia South Africa
Venezuela Venezuela Lithuania Bulgaria
PWT adjusts real GDP for purchasing power parity (PPP), which is the number of local currency units required
to buy the same amount of goods that can be bought with one unit of the base currency (the U.S. dollar). PWT
Argentina Bulgaria Latvia Venezuela
The Record: Enduring Strengths or a Bounce Back?
7
III THE RECORD: ENDURING STRENGTHS OR A BOUNCE BACK?
Figure 3.2. CEECs and Other Emerging Market Regions:

Growth in Real Per Capita GDP
(In percent)
15 15
CE-5 Baltic Countries
10 10
5 5
0 0
–5 –5
Czech Rep. Estonia
–10 Hungary Latvia –10
Poland Lithuania
–15 Slovakia –15
Slovenia
–20 –20
–25 1990 92 94 96 98 2000 02 04
–25
1990 92 94 96 98 2000 02 04
15 15
East Asia Latin America
10 10
5 5
0 0
–5 –5
–10 –10
China Philippines Argentina Mexico
–15 Hong Kong SAR Singapore Brazil Peru –15
Indonesia Thailand Venezuela
–20 Taiwan Province of China Chile –20
Korea
Malaysia Colombia
–251990 92 94 96 98 2000 02 04
–25
1990 92 94 96 98 2000 02 04
Sources: Penn World Tables; and IMF, World Economic Outlook.
Figure 3.3. Employment Rates in the CEECs

(In percent of population, ages 15–64)
85
80
Latvia
75
70
Hungary Czech Rep.
Estonia
65
Lithuania
Slovakia
60
Slovenia
55
Poland
50
1990 92 94 96 98 2000 02 04
Source: IMF, World Economic Outlook.

Figure 3.4. Contributions to Average GDP Growth

(In percent)
Overall GDP growth Employment Capital TFP

8
-2
-4
4 9 4 4 9 4 4 9 4 4 9 4 4 9 4
0–9 5–9 0–0 0–9 5–9 0–0 0–9 5–9 0–0 0–9 5–9 0–0 0–9 5–9 0–0
199 199 200 199 199 200 199 199 200 199 199 200 199 199 200
CE-5 altic Countries East sia atin m erica OECD Countries
-2
-4
4 9 4 4 9 4 4 9 4 4 9 4 4 9 4 4 9 4
0–9 5–9 0–0 990–9995–9000–0 990–9995–9000–0 990–9995–9000–0 990–9995–9000–0 990–9995–9000–0
199 199 200 1 1 2 1 1 2 1 1 2 1 1 2 1 1 2
CE-5 altic Countries Emerging Mar et Emerging Mar et Emerging Mar et Emerging Mar et
Countries Countries Countries Countries
Quartile 1 Quartile 2 Quartile Quartile 4
distribution (Figure 3.7). With considerably more that capital is underestimated (e.g., because of over-
variation in investment rates (the Czech Republic, estimates of depreciation) or gray market employment
Estonia, and Latvia at the higher end of the emerg- is hiding actual labor inputs, TFP is overestimated.
ing market country spectrum and Poland at the lower Still, it is widely accepted qualitatively that produc-
end), foreign savings have played a key role in sev- tivity gains have accounted for a substantially larger
eral countries. share of growth in the CEECs than in other emerg-
Another distinguishing feature of CEEC growth ing market countries and that the Baltics stand out in
has been an especially high contribution of TFP to this regard. Within-industry efficiency gains—from
growth. Measured as a residual, the size of the con- privatization, increased market incentives, the adop-
tribution is necessarily approximate. To the extent tion of new technologies and managerial methods, and

Box 3.1. Compositional Shifts in Output: Implications for Productivity Growth
Caselli and Tenreyro (2005), examining broad sec- new investment has been an instrument for resource
toral data (agriculture, industry, and services), find reallocation, reflected in increased shares of the high-
that productivity gaps between CEECs and advanced technology sectors in industrial production. Information
economies arise mainly from lower productivity in and communication technology (ICT) sectors, which
each sector. They find that reallocation of resources to have relatively high total factor productivity (TFP) levels
more productive sectors has helped reduce the gap, but and growth rates, have also risen from less than 10 per-
that this has not been an important source of produc- cent to more than 30 percent of industrial production in
tivity growth. Industry- and firm-level data generally the past decade (see figure). The implication is that con-
support these conclusions. Specifically, labor shares tinued strong productivity growth will depend in part on
have been broadly stable across industrial sectors, sug- “climbing the technology ladder” and rapid productivity
gesting that labor reallocation has not contributed to an growth in the ICT sectors. Given the relatively small
increase in labor productivity. Indeed, labor realloca- share of ICT-producing sectors in total output in most
tion has had small negative effects on productivity in CEECs, however, Piatkowski (2006) argues that ICT-
some CEECs (see table). producing sectors cannot drive the convergence process;
Firm-level data, available at this time only for Hun- instead, increased use of ICT by other sectors will be the
gary (Kátay and Wolf, 2006), however, suggest that important driver of productivity growth.
Labor Productivity in the CEECs, 1994–2002
Czech Rep. Estonia Hungary Lithuania Latvia Poland Slovakia Slovenia
Total labor productivity

growth, 1994–2002 42.4 100.3 90.0 84.6 68.0 97.9 87.7 32.2
Within-industry gains
in productivity 51.9 109.6 73.8 73.4 64.5 92.4 85.6 29.3
Of which:
Gains due to
reallocation of
labor across sectors –9.5 –9.2 16.2 11.2 3.5 5.5 2.1 2.9
Source: IMF staff calculations.
the bounce back from sharp output losses in the initial fore soon trail off—is a key question for prospective
stages of transition—undoubtedly played a significant growth.
role in raising production levels without commensurate In sum, this review, which shows the greatest common-
increases in the inputs. But shifts in the composition ality across the CEECs in their low labor utilization and
of output toward high-productivity sectors appear also high TFP growth, also points to a few key questions:
to be playing a role (Box 3.1). Whether the TFP gains
achieved thus far have eliminated the most egregious • To what extent have the relatively rapid growth rates
inefficiencies of central planning—and will there- since the mid-1990s been the result of favorable
10

Hungary:TFP Growth in the Largest 10 Industries, 1994–2002

(Annual average, in percent)
Shares in Industrial
1994–98 1999–2002 Production
(In percent)
1993 2002
Communications equipment 2.9 15.7
Food and beverages 20.0 13.1
Machinery 9.2 8.8
Chemicals 16.4 8.4
Fabricated metal products 5.8 8.4
Office machinery/computers 0.4 7.9
Electrical machinery 5.4 7.4
Motor vehicles 3.8 5.1
Rubber and plastic products 3.4 4.6
Publishing/printing 4.4 3.6
–2 0 2 4 6 8 10
Source: IMF staff estimates.
underlying conditions that will sustain growth, or • Is there a problem with the recent experience, par-
of bounce backs from the large output losses in the ticularly in the Baltic countries, of increases in
early transition period? capital input financed by large capital inflows?
• What are the policy priorities for sustaining high • To what extent does integration with Western Europe
growth in the Baltics and raising them in the CE-5? provide opportunities for growth that fundamen-
What can be learned from the experience of other tally differentiate the CEECs from other emerging
countries? market countries?
11

Figure 3.5. Employment and Activity Rates in Emerging Market Economies, 2004
(In percent of working-age population)
Employment rate Activity rate

100
90
80
70
60
50
40
30
20
10
0
Czech Rep.
China
Thailand
Brazil
Indonesia
Hong Kong SAR
Singapore
Russia
Korea
Estonia
Malaysia
Latvia
Bulgaria
Philippines
Mexico
Venezuela
Lithuania
Colombia
Israel
Hungary
Slovakia
Slovenia
Romania
Chile
Poland
Croatia
Morocco
Jordan
Pakistan
Turkey
Egypt
South Africa
Argentina
Peru
Figure 3.6. Investment and Growth in

Emerging Market Economies, 2000–04
8
Growth in real PPP GDP per capita, 2000–04
Estonia
Lithuania Latvia
6
Hungary
Slovakia
4
Poland Slovenia
Czech Rep.
2
–2
10 20 30 40 50
Investment/GDP, 2000–04
Sources: IMF, World Economic Outlook; and Penn World Tables.
12

0
10
20
30
40
50
60
0
10
20
30
40
50
60
China Singapore
Czech Rep. China
Estonia Malaysia
Korea Venezuela
(In percent of GDP)
Latvia Hong Kong SAR

India Korea
Croatia India
Malaysia Russia
Savings Rates
Bulgaria Czech Rep.

Slovenia Thailand
Investment Rates
Singapore
Market Economies, 2004
Slovenia
Hungary

Chile
Hong Kong SAR Morocco
Slovakia Philippines
Sri Lanka
Taiwan Province of China
Baltic countries
Morocco
Indonesia
Chile
Croatia
Thailand
Slovakia
Indonesia
Egypt
Lithuania
Sri Lanka
Venezuela
Argentina
CE-5
Turkey
Romania Bulgaria
Philippines Brazil
Mexico Mexico
Russia Pakistan
Peru
Figure 3.7. Savings and Investment Rates in Emerging
Taiwan Province of China

Estonia
Others
Poland
Peru Poland
Argentina Latvia
Pakistan Hungary
Colombia Colombia
Brazil Israel
South Africa Turkey

Egypt South Africa
Israel Romania
Lebanon Lithuania
13
IV Growth Scenarios: Possible Paths for the
Catch-Up
he speed at which income gaps with the euro area lations remain stable, labor input will grow at a rate of
T could be closed varies considerably across the
CEECs (Table 4.1). Countries with per capita incomes
just under 1 percent a year, contributing about per-
centage point annually to income per capita growth.
close to the euro area average need to go a shorter dis- This trajectory, also envisaged in OECD (2004),
tance and hence are better positioned to achieve income would translate into a cumulative 5–6 percent increase
convergence. At about $19,000 (in real purchasing power in GDP per capita over the next 10 years. If increased
parity (PPP) terms), Slovenia’s annual per capita income participation is achieved principally by bringing low-
was 74 percent of the euro area average in 2004. At productivity workers into the workforce, the growth
the other extreme, Latvia’s per capita income of about dividend will be less.
$11,000 was 43 percent of the euro area average. If Even assuming such a contribution from employ-
per capita incomes in the euro area grow at 2 percent ment, large increases in investment and productivity
a year, Slovenia, which has the shortest distance to go, would be needed for a rapid catch-up. This is illustrated
can, at its current growth rate, reach 90 percent of the by considering investment and productivity require-
euro area average in 12 years. Even if growth slows, as ments needed to close half the 2004 income gap with
the analysis in the next section suggests it will, 90 per- the euro area. An ambitious policy objective would
cent of the euro area average could be achieved in about be to reduce the half-life predicted in Table 4.1 by 20
16 years. The relatively low-income but rapidly growing percent. For example, instead of closing half its income
Baltics are well positioned to close half their gaps in gap with the euro area in 20 years, the challenge to
the next 10–15 years, even if growth slows from recent Slovakia would be to close it in 16 years. Two scenarios
rates. At the other extreme, Poland with both a rela- define the possible demands on productivity growth
tively low per capita income and low growth could take and investment:
over 70 years to reach 90 percent of the euro area aver-
age barring underlying changes to growth prospects. • The first scenario fixes the productivity growth
Catch-up will be helped by raising employment but rate and determines the required investment rate to
will depend more significantly on increased capital- achieve the ambitious policy objective defined above.
labor ratios and productivity of resource use. Employ- The long-term productivity growth is assumed to be
ment rates are low when seen in an international around 1.6 percent a year, the average achieved by
context. Most, however, are only modestly lower than East Asian economies during 1990–2004. Since the
the average in the euro area, and a few are equivalent Baltic countries currently exceed this productivity
to or even exceed the euro area average (Table 4.2). growth by a large margin, their rate of productivity
Still, countries will need to aim for higher employ- growth is assumed to decline gradually over the
ment rates alongside similar efforts in the euro area. next 10 years to 1.6 percent a year.
From the catch-up point of view, the greatest scope for
• The second scenario fixes investment/GDP at their
advancement lies in increasing the capital-labor ratios,
current (2000–04) average and determines produc-
which range from less than a fifth to about half of the
tivity growth rates needed to achieve the targeted
euro area average, and are ordered precisely accord-
catch-up.
ing to gaps in per capita GDP. High rates of invest-
ment will, therefore, be important. TFP gaps, in the In the first scenario, with productivity growth set at
range of one-third to two-thirds, are smaller than those realistic, but high, rates, investment would need to be
for capital-labor ratios, but they are substantial and extremely strong in some countries (Table 4.3). The
catch-up possibilities will depend crucially on raising Czech Republic, Hungary, and Slovakia would need to
productivity. raise investment rates by between 12 and 15 percent-
A step up in labor input will be an essential contri- age points to between 35 percent and 42 percent of
bution to growth. If employment rates can be raised GDP. Others would need smaller but still significant
steadily by about percentage point a year and popu- increases. The large jumps reflect the combination of
14

Growth Scenarios: Possible Paths for the Catch-Up
Table 4.1. CEECs: Convergence with Euro Area Income Per Capita1
2004 Income Per Based on Actual 2000–04 Growth

________________________________ Based on Predicted 2005–09 Growth2
________________________________
Capita Relative to Years to close Years to reach per Years to close Years to reach per
Euro Area, PPP half the capita income ratio half the capita income ratio
(In percent) income gap of 90 percent income gap of 90 percent
Czech Rep. 69 14 26 11 19
Estonia 49 6 16 12 34
Hungary 59 10 24 14 33
Latvia 43 7 22 14 41
Lithuania 46 7 21 12 33
Poland 46 27 79 25 73
Slovakia 52 17 45 20 54
Slovenia 74 8 12 10 16
Sources:World Bank, World Development Indicators; and IMF staff calculations.

1The convergence half-life is calculated as ln(2)/B, where B = (g – g*)/ln(Y/Y*), g is per capita income growth, Y is the per capita income level in PPP
terms, and * indicates the euro area.

2Predictions drawn from the empirical estimates in Section V.
Table 4.2. Decomposing the Income Gap Between the Euro Area and the CEECs
Total Factor Productivity

Per Capita Income Capital Per Worker
____________________ Employment Rate
____________________ (TFP)
____________________
Income Ratio Relative to Relative to Relative to
(Real PPP, Versus U.S. dollar euro area In euro area euro area
U.S. dollar) Euro Area per worker (In percent) percent (In percent) (In percent)
Czech Rep. 17,937 69 50,016 34 64.2 102 304 40

Estonia 12,773 49 32,269 22 63.0 100 321 42
Hungary 15,399 59 41,295 28 56.8 90 336 44
Latvia 11,148 43 28,329 19 62.3 99 288 38
Lithuania 12,051 46 22,008 15 61.2 97 321 42
Poland 11,921 46 31,844 22 51.7 82 367 48
Slovakia 13,437 52 38,193 26 57.0 91 277 36
Slovenia 19,251 74 64,857 44 65.3 104 490 64
Sources:World Bank, World Development Indicators; Eurostat; IMF, World Economic Outlook; and IMF staff calculations.
Note: TFP is calculated as Y/(K0.35·L0.65).
currently high productivity growth, which would fall part clustered around 3 percent—a substantial increase
in this scenario to 1.6 percent a year, and the fact that for the Czech Republic and Poland and at recent, rela-
capital-output ratios are already relatively high (espe- tively high rates for Hungary and Slovakia. For the Bal-
cially in the Czech Republic). While capital-labor ratios tics, maintaining current investment rates along with
will rise as a consequence of the higher investment rates, an ambitious catch-up objective would be possible with
they will still remain substantially below the euro area productivity growth rates in the range of 3 percent to
average. Although the investment rates implied by this 4 percent a year—rates that are lower than averages
scenario have been achieved in some East Asian coun- for the past five years but still high by emerging market
tries, they have been supported there by significantly country standards. A key question for such scenarios is
higher domestic savings rates than in the CEECs. whether high TFP growth could occur in the absence of
The second scenario, which fixes CEEC investment stronger investment.
relative to GDP at the 2000–04 averages, shows a sig- The conditions underlying these scenarios illustrate
nificant productivity challenge (Table 4.4). Among the the challenges CEECs face in sustaining a rapid catch-
CE-5, the required TFP growth rates are for the most up. The literature has similarly emphasized the policy
15

IV GROWTH SCENARIOS: POSSIBLE PATHS FOR THE CATCH-UP
Table 4.3. Scenario 1: Speeding Up Convergence in the CEECs Through Higher Investment
Total Factor
Productivity
Investment
____________________ (TFP) Growth
____________
Target Growth Rate Contributions (in Percent) of
______________________________ 2000–04 2000–04
(In percent a year)1 TFP2 Labor3 Capital4 Required average average
Czech Rep. 4.3 1.6 0.5 2.2 42.2 27.2 1.5

Estonia 6.1 3.4 0.5 2.1 29.5 27.7 5.2
Hungary 4.6 1.6 0.6 2.4 35.3 23.1 2.9
Latvia 6.5 3.7 0.5 2.3 31.1 24.8 5.8
Lithuania 6.6 3.4 0.5 2.7 26.3 20.6 5.2
Poland 4.3 1.6 0.6 2.1 25.1 20.0 1.8
Slovakia 4.4 1.6 0.6 2.2 38.6 26.5 3.0
Slovenia 3.9 1.6 0.5 1.8 27.4 24.3 1.7
Sources: IMF, World Economic Outlook; and IMF staff calculations.

1Growth rate in 2005–09 that corresponds to a half-life 20 percent shorter than in column 4 of Table 4.1.
2TFP growth is assumed to be 1.6 percent for the CE-5 and gradually declining to that level for the Baltics over 10 years.
3Employment rates are assumed to increase by percentage point a year and labor’s share is 0.65.
4Calculated as a residual.
Table 4.4. Scenario 2: Speeding Up Convergence in the CEECs Through Higher

Productivity Growth
Total Factor
Target Growth Rate Contributions (in Percent) of
______________________________________ Productivity (TFP)
(In percent a year)1 Capital2 Labor3 TFP4 Growth, 2000–04
Czech Rep. 4.3 0.8 0.5 3.0 1.5

Estonia 6.1 1.9 0.5 3.7 5.2
Hungary 4.6 1.0 0.6 3.1 2.9
Latvia 6.5 1.4 0.5 4.5 5.8
Lithuania 6.6 1.7 0.5 4.4 5.2
Poland 4.3 1.3 0.6 2.4 1.8
Slovakia 4.4 1.0 0.6 2.9 3.0
Slovenia 3.9 1.4 0.5 2.0 1.7

1Growth rate in 2005–09 that corresponds to a half-life 20 percent shorter than in column 4 of Table 4.1.
2Assumes investment/GDP remains at 2000–04 averages.
3Employment rates are assumed to increase by percentage point a year and labor’s share is 0.65.
4Calculated as a residual.
challenges. OECD (2004) draws attention to the labor scope for rising capital-output ratios, Doyle, Kuijs,
market reforms needed to ensure a contribution of and Jiang (2001) caution that little is known about
labor input similar to that assumed in the scenarios the quality of the capital stock in the CEECs: if
here. It also, however, recognizes that this alone will depreciation rates turn out to be higher than typically
not be enough; continued rapid productivity growth is assumed, investment rates needed to secure given
essential. Crafts and Kaiser (2004) envisage limited capital contributions could be even larger than the
support from increased labor inputs or sharp rises scenarios suggest. And given the low savings rates in
in capital-output ratios, and therefore place an even the CEECs, significantly larger contributions of capi-
heavier weight on productivity gains. Further to the tal to growth to compensate for shortfalls in labor or
16

Growth Scenarios: Possible Paths for the Catch-Up
TFP contributions would require unprecedented use above average productivity growth.” Labor productivity
of foreign savings. in Spain went from 65 percent of that of France to over
While the challenge is considerable, high rates of 90 percent between the late 1950s and the early 1970s.
productivity growth may indeed be possible. Caselli Similarly, Ireland did not just converge but raised its
and Tenreyro (2005), drawing on the historical experi- productivity level to one of the highest in Europe. Since
ence of Western Europe, conclude that remarkably high the process of integrating with Europe seems to have
productivity growth has occurred in spurts. Describ- driven this productivity-led convergence process, they
ing Western Europe as the “quintessential convergence conclude that the CEECs should also be able to benefit.
club,” they note that “Italy first, then Spain, Greece, They point, however, to the importance of human capi-
Portugal, and eventually Ireland all had their spurts of tal development in making this possible.
17

V Policies and Long-Term Growth: What
Can Be Learned from Other Countries?
losing the income gap with Western Europe will • Geographic and socioeconomic attributes constitute
C require supporting policies in the CEECs. The
growth accounting exercise presented in the previ-
32 of the 67 variables. Some (such as prevalence of
malaria and whether a country is landlocked) have
ous section is a mechanical one. It assumes that the an obvious bearing on the costs or availability of
CEECs—at speeds varying according to their levels factor inputs, but many others (such as the East
of development and recent histories—will continue to Asian and African dummy variables and ethnic
close their factor utilization and TFP gaps vis-à-vis variables that reflect religious composition and lan-
Western Europe. But that is not an assumption to be guage attributes) have less obvious links to produc-
made lightly. The recent debate on growth has centered tive potential.
on whether policies and institutions can speed up, or
impede, the closing of income gaps. In other words, is • Another 20 variables capture structural features
the sheer existence of gaps enough to set in play forces with analytically clear links to growth potential.
that will close them, or must policies and other support- These include initial income per capita (lower lev-
ing conditions play a role? els create room for higher incremental product of
This section is divided into two parts. The first sum- capital and technological leapfrogging) and demo-
marizes the most robust conclusions of earlier studies graphic factors such as population growth rates,
on the determinants of long-term growth. The second fertility rates, and age composition (ceteris paribus,
updates estimates of growth models to assess the per- lower population growth means more capital accu-
formance of the CEECs relative to their peers. mulation per worker and hence higher productivity
growth, while fertility rates and age composition
determine the size of the workforce for a given
population). Included in this group are institutional
Lessons from Large Sample variables, such as measures of political rights and
Studies of Long-Term Growth civil liberties.
• The remaining 15 variables are those most amenable
A vibrant literature of empirical growth studies lends
to policy influences. Three variables are measures
support to a variety of views on the conditions and poli-
of education (primary schooling, higher education,
cies that spur growth. Because economic theory does
and public spending on education). Another three
not reach clear conclusions on the conditions that best
measure openness (a variable constructed by Sachs
support income catch-up, researchers have looked for
and Warner (1995) identifying the number of years
lessons from the experience of a large number of coun-
that a country had an “open” trade regime, and
tries over long periods. The challenge is to sift through
two indices of “outward orientation” constructed by
the voluminous (and at times contradictory) conclu-
Levine and Renelt (1992)). Six variables capture the
sions to identify the most robust influences—those that
role of the government (including the size of gov-
are repeatedly significant across studies covering dif-
ernment and the composition of spending). Infla-
ferent samples, periods, and specifications.
tion and the square of inflation represent monetary
A good starting point is the metastudy by Sala-i-
conditions.
Martin, Doppelhofer, and Miller (2004; henceforth,
SDM). It examines the role of 67 variables (found to From this large set of variables, SDM identify a
be significant determinants of growth in many earlier small range of policy variables with consistent links to
studies) in 88 countries from 1960 to 1996. To mini- growth. The cost of investment and (primary) school-
mize the possibility that growth may be influencing the ing have the most robust link to growth, but greater
variables thought to be the determinants, most explana- trade openness (the number of years with an “open”
tory variables are set at values of the early 1960s. The trade regime and the ratio of exports and imports to
variables may be grouped in three categories: GDP) and smaller government (government consump-
18

Lessons from Large Sample Studies of Long-Term Growth
tion as a share of GDP) also contribute significantly national trade agreements); (2) assessments of public
to growth. Among the structural variables (from the institutions (quality of governance, legal protections
second grouping described above) are initial per capita of private property, and limits placed on politicians); 8
GDP and, with less consistency, population growth. and (3) most ambitiously, the “deep determinants” of
These results lead to the troubling conclusion that the growth, which are essentially institutions with a long
scope for policies to affect growth may be rather nar- historical reach, arising, for example, from patterns of
row or influenced by other conditions in ways that are colonization and settlement and alternative legal frame-
difficult to discern. Some observers question whether works (for example, civil versus common law).9 Institu-
the dominant influence on growth of a country’s struc- tional quality is particularly important to investigate for
tural and institutional history leaves little role for poli- the CEECs, where the institutions of central planning
cies (IMF, 2003; and Easterly, 2005). Alternatively, were a key constraint on growth prior to transition, pro-
growth regressions may simply not be good at identi- found institutional change has taken place in the past
fying policy effects on growth: they have the strength one-and-a-half decades, and further change will occur
of drawing on the experience of many countries, but to conform to EU institutions.
the weakness of largely atheoretical structures that do The role of financial development in growth has
not account for the complexity of complementarities generated much more controversy. Efficient financial
in growth determinants (World Bank, 2005). In other systems should help raise investment and spur risk tak-
words, a certain package of policies may be good for ing and innovation. Thus, still-underdeveloped finan-
growth, yet any policy individually may not be sta- cial markets in the CEECs may be an impediment to
tistically significant. Also, the context in which poli- growth (Levine, Loayza, and Beck, 2000; and Beck,
cies are implemented (e.g., the stage of development Levine, and Loayza, 2000). But most common mea-
or specific historical features), which cannot be fully sures of financial development (ratios of bank credit
captured in studies that cover many countries, may be or stock market capitalization to GDP) do not have
critical to their effects on growth (Aghion and Howitt, systematically significant relationships to growth. And
2005). Moreover, unmeasurable influences on growth when a significant relationship is found, it may reflect
may interact with measurable policies. It is worthwhile, a cyclical rather than secular influence (Bosworth and
therefore, to probe beyond the SDM metastudy for fac- Collins, 2003). Moreover, indicators of financial devel-
tors that may be particularly important in the CEECs. opment and financial booms are indistinguishable. The
Preparation for EU accession—especially institu- World Bank (2005) concludes that, in the 1990s, unless
tional reform and opening to trade—was a key part of financial liberalization was accompanied by prudential
the context for the CEECs in the period under review. safeguards, it was more prone to generate crises than to
The dismantling of trade barriers increased product spur growth. These concerns have led to an alternative
market competition and induced efficiency improve- way of accounting for the effect of financial develop-
ments. Moreover, trade has stimulated specialization, ment: assuming financial development is endogenous
with growth effects amplified by the formation of man- to institutions (especially for enforcing contracts), a
ufacturing agglomerations.7 The process is likely also comprehensive measure of institutional quality should
to have added to the momentum—already established capture its influence on growth (Levine, 1997).
in the process of adopting the aquis communautaire— Another continuing puzzle is the effect of fiscal pol-
of institutional reform. Such an effect of trade openness icy on growth. This is a clear case where the complex-
is documented in Rajan and Zingales (2003) and Abiad ity of policy interactions with growth across diverse
and Mody (2005). countries is hard to specify. Leaving aside short-term
Evidence of the importance for growth of institu- Keynesian effects, government operations can affect
tional quality is expanding. SDM consider the influence growth through several channels. Government size is
of political rights and civil liberties on growth, but do an obvious one: as governments collect a larger share
not find them significant. Other recent studies point to of the GDP in taxes, the likelihood of disincentives to
a large and statistically significant role of legal, politi- work and invest increases. But the strength of this influ-
cal, and administrative characteristics in growth per- ence depends on tax structure and the government’s
formance (IMF, 2003). In essence, institutions set the
“rules of the game” that determine the incentives for 8Assessments of public institutions are based on indices such
production, investment, and consumption. In empirical as those in the International Country Risk Guide (ICRG). This
analyses, institutions have been characterized at three publication for investors includes five indices of perceptions of gov-
levels: (1) organizational entities and regulatory frame- ernment stability, democratic accountability, law and order, quality
works (such as central bank independence and inter- of bureaucracy, and corruption in government. Keefer and Knack
(1997) initiated this inquiry. Burnside and Dollar (2000); Gallup,
Sachs, and Mellinger (1999); and Crafts and Kaiser (2004) find
similarly robust effects of ICRG variables.
7Sachs and Warner (1995) discuss these and other benefits of 9Acemoglu, Johnson, and Robinson (2001); and Glaeser and oth-
trade openness. ers (2004).
19

V POLICIES AND LONG-TERM GROWTH
ability to provide public goods. Also, the size of budget lapping averages. The results from the two exercises
deficits, the composition of expenditures, procyclicality are quite similar, although the global sample generates
of revenues and expenditures, and volatility of discre- predictions of per capita GDP growth closer to actual
tionary expenditures may influence long-term growth performance. This suggests that as long as differences
(Aghion and Howitt, 2005; Fatás and Mihov, 2003). in convergence rates stemming from differences in
Most panel data studies do not find a direct effect of the institutional quality are accounted for, there is no need
size of fiscal deficits on growth: an exception is Adam to consider advanced and less advanced country growth
and Bevan (2005) who find that growth is reduced at processes separately.
high budget and public debt thresholds.10 Thus, while As in most other studies, the results show that factors
theory suggests channels through which deficits and outside the immediate control of policies have strong
government size should matter for growth, the latter is and robust effects.
found to be the more consistent influence.
A consideration of central importance to surveillance • A lower level of per capita income is associated with
is the role of the exchange rate regime. The strong per- higher growth. However, this influence depends on
formance of the currency board CEECs (Estonia and institutional quality. Where per capita income and
Lithuania) begs the question of whether such arrange- institutional quality are both low, the ability to take
ments help growth. In fact, little global support exists advantage of growth opportunities is limited. This
for this view. Ghosh, Gulde, and Wolf (2002) find effect is captured by the composite convergence
fixed exchange rates are associated with lower infla- term B0 + B1 • InstitutionalQuality. For most coun-
tion: this should have an indirect benefit for growth. tries the composite term is negative, implying at
But if a fixed regime is not supported by sound fiscal least modest convergence. The negative coefficient
policies, imbalances may build up, reflected in overval- on B1 implies that as institutional quality improves,
ued currencies and lower growth. Husain, Mody, and convergence accelerates (Figure 5.1).
Rogoff (2005) find that especially in advanced econo- • More rapid population growth is associated with
mies, flexible exchange rates may enhance growth by slower per capita GDP growth. Common to many
increasing shock absorption capacity. studies, this finding needs to be interpreted with
caution. Slow population growth in the CEECs will
be accompanied by changes in age structure, itself
Updated Estimates of Growth likely to have considerable but difficult-to-predict
Determinants influences on growth. As in other analyses, addi-
tional demographic variables, such as dependency
This section reports estimates of a relatively spare ratios and labor force participation rates, were not
specification of a growth equation. The aim is to use significantly correlated with growth.
up-to-date data and experiences of many countries to
• Growth in trading partners has a positive effect
identify key determinants of growth for the CEECs and
on growth. The past decade’s experience raises the
to form a view of growth prospects that complements
question of whether established patterns of trade
the growth accounting perspective. The appendix
with slow-growing partners hinders a country’s
describes the methodology and results.
growth rate, or whether countries can shift between
Broad and narrow samples were used to establish
global export markets quickly enough to take equal
the relevant peers. The first, a global sample with data
advantage of the fastest growing markets. Results
from 125 countries, follows the conventional approach
suggest that historical trade patterns have lasting
of growth studies. However, unlike standard prac-
effects on growth, in line with EBRD (2004) and
tice, which forces a uniform speed of convergence,
Arora and Vamvakidis (2005).
the estimation allows for differences in the speed of
convergence across countries with different levels of Several factors influenced directly or indirectly by
institutional quality (Table 5.1). The second, a narrow policies have the expected significant (though gen-
sample, including 59 advanced and emerging market erally weaker than nonpolicy variables) effects on
countries, is designed to investigate whether growth growth.
processes differ fundamentally between low-income
and more advanced countries. Each exercise uses data • The relative price of capital goods, as a proxy
from 1984 to 2004 in the form of five-year nonover- for the costs of investment, is directly related to
growth.
10Fischer,
• Years of schooling, a generalized measure of
Sahay, and Vegh (1996), for example, find that the
size of fiscal deficits does not directly affect either inflation or
human capital, is a robust determinant of growth
growth once the influence of structural reforms has been taken into in the global sample. That it is a less strong influ-
account. ence in the narrow (advanced and emerging market
20

Updated Estimates of Growth Determinants
Table 5.1. Growth Regression Estimates1
Dependent Variable: Growth Rate of Per Capita GDP (Measured at PPP)

Sample Period: Five-Year Nonoverlapping Averages, 1985–89 to 2000–04
Advanced and Emerging

Global Sample
___________________________ Market Country Sample
___________________________
Explanatory Variable Coefficient t-statistic Coefficient t-statistic
Log of per capita GDP 1.36 (1.89) –2.27 (6.34)

Population growth –1.46 (8.94) –1.27 (7.42)
Partner country growth 0.62 (3.39) 0.61 (3.24)
Relative price of investment goods –0.22 (0.84) –0.75 (2.41)
Schooling 0.45 (2.53) 0.20 (1.40)
Openness ratio 0.01 (3.01) 0.01 (3.85)
Government taxation ratio –0.05 (2.47) –0.02 (1.20)
Institutional quality 0.41 (4.07) 0.03 (1.88)
Institutional quality * log of per capita GDP –0.04 (3.86)
Dummy, 2000–04 –10.66 (1.69) 20.93 (6.74)
Dummy, 1995–99 –11.32 (1.80) 20.31 (6.50)
Dummy, 1990–94 –10.33 (1.65) 20.96 (6.72)
Dummy, 1985–89 –11.12 (1.78) 20.51 (6.50)
Number of observations 96, 84, 52, 56 58, 51, 41, 41
R-squared 0.47, 0.02, 0.3, 0.37 0.58, –0.17, 0.36, 0.36

1Estimation is by seemingly unrelated regression.
Figure 5.1. Global Sample: Institutional Quality and the Speed of Convergence
1st quartile, institutional quality 2nd quartile, institutional quality
3rd quartile, institutional quality 4th quartile, institutional quality
20
15
Average five-year growth
10
–5
–10
–15
5 6 7 8 9 10 11
Log of initial real per capita GDP
Sources: Political Risk Services, International Country Risk Guide; Penn World Tables; and IMF staff calculations.
Note: Observations grouped by quartile of institutional quality.
21

Box 5.1. Measuring Institutional Quality in the CEECs

Institutional quality in the CEECs has some impor- a variety of policy benchmarks in the transition from
tant dimensions specifically related to transition. Does central planning to market mechanisms, is highly cor-
the International Country Risk Guide (ICRG) index pick related with the institutional quality measure used in this
them up? The transition index of the European Bank for paper (see figure). Components of the transition index
Reconstruction and Development (EBRD), which reflects that display particularly high correlation with the insti-
tutional quality index include some measures that were
taken early in the process—enterprise restructuring and
large-scale privatization—but also more contemporary
Institutional Quality and the EBRD policy tasks such as enhancing competition, financial sec-
Transition Index tor deregulation and development, and trade liberalization
(see table).
4
Institutional Quality and the EBRD Transition
Subindices
EBRD transition index
Correlation with ICRG

EBRD Subindices Composite Index
2
Enterprise restructuring 0.85
Competition policy 0.83
1 Financial liberalization 0.81
Large-enterprise privatization 0.81
Trade and foreign exchange
liberalization 0.79
0 Securities markets 0.79
0.2 0.4 0.6 0.8 1 Small-scale privatization 0.61
ICRG institutional quality Price liberalization 0.48
Sources: Political Risk Services, International Country Risk Sources: Political Risk Services,International Country Risk Guide
Guide (ICRG); and European Bank for Reconstruction and
(ICRG); European Bank for Reconstruction and Development
Development (EBRD).
(EBRD), and IMF staff calculations.
country) sample may indicate that quality of edu- cial development (private credit/GDP, stock market
cation, rather than quantity alone, becomes more capitalization/GDP) were not found to be signifi-
important as countries advance. cant, this variable is likely to be indirectly pick-
ing up effects of financial development on growth.
• Openness to trade, measured as the ratio of trade
For the CEECs, the variable is also correlated with
to GDP, corresponds inversely to the extent of tar-
progress in shifting from central planning to mar-
iff and nontariff barriers and significantly helps
ket mechanisms (Box 5.1).
growth. Likely channels include enhanced com-
petition, greater specialization, and pressure to • Monetary conditions were found to have a sig-
improve the business climate. nificant effect on growth through the influence
• Fiscal policy is found to influence growth through of inflation relative to a threshold of 50 percent
the size of government—larger governments appar- (rates higher than the threshold hurt growth). The
ently pull growth down. The size of the budget exchange rate regime was not found to have a sig-
deficit was not found to have an independent effect nificant effect.11
on growth across countries.
• The ICRG composite index, as a proxy for the
quality of institutions, has a significant positive
11Results excluding inflation are shown in the box and used in the
effect on growth and is a key factor in differenti-
ating the speed of catch-up as between advanced rest of the analysis, because omitting the variable had virtually no
effect on other estimates and inflation in the CEECs is well below
and low-income countries. As indicators of finan- the threshold.
22

Interpreting the Strengths and Weaknesses of the CEECs
The estimates predict actual per capita growth rates

Figure 5.2. Emerging Market Economies: during 2000–04 well in the CE-5 but less well in two
Actual and Predicted Per Capita GDP of the Baltic countries (Figures 5.2 and 5.3). Using the
Growth, 2000–04 results of the global sample model, predicted annual per
(In percent, annual average) capita growth rates for 2000–04 at about 3 percent to
4 percent for the CE-5 and almost 7 percent for Lithu-
ania are close to actual growth rates. For Estonia and
Actual growth Prediction Latvia, however, the predicted growth rates of about 6
8 7.6 percent are below actual growth rates of almost 8 per-
cent. The model’s higher growth prediction for Lithuania
7 6.6 vis-à-vis Estonia and Latvia can be traced to two factors:
6 smaller government size and a low per capita income in
Lithuania (combined with better institutions relative to
5 Latvia). The underprediction of growth in Estonia and
4
4.0 Latvia and the prediction of reduced growth rates in all
3.6 3.6 3.7
the Baltic countries as the income gap vis-à-vis the euro
3 area diminishes raises questions about continued perfor-
2.2 mance at current rates.
2
1.0
1
0
Interpreting the Strengths and
Baltic
Countries
CE-5 East Asia Latin America Weaknesses of the CEECs
Source: IMF staff estimates. During 2000–04, exogenous conditions favored
growth in the CEECs but overall policy conditions were
mixed relative to East Asia—a useful comparator (Fig-
ure 5.4). Despite higher initial per capita income in the
CE-5 than in East Asia, slower population growth gave
the CE-5 an edge of between 1–2 percentage points
Figure 5.3. CEECs: Actual and Predicted Per Capita GDP

Growth, 2000–04
(In percent, annual average)
Actual growth Prediction
9
8 7.8 7.8
7.1
6.9
7 6.5
6.2
6
5
4.3
4.1
4 3.8 3.7 3.7
3.5 3.3 3.4
3.2
2.9
3
2
1
0
Latvia Estonia Lithuania Hungary Slovakia Slovenia Poland Czech Rep.
23

average, had smaller governments, higher educational

Figure 5.4. Per Capita GDP Growth in attainment, and greater openness (the latter owing fully
the CE-5 and Baltic Countries Relative to to Hong Kong SAR and Singapore), but the CE-5 on
Other Emerging Market Regions, 2000–04 average had better scores for institutional development.
(In percentage point differences) The Baltics are less disadvantaged vis-à-vis East Asia
with respect to their “policy” package, despite lower
average institutional development, and substantial
Actual Exogenous variables gains in institutional quality in the Baltic countries in
Policy-influenced variables Total the run-up to EU accession have likely narrowed this
6 disadvantage.
Per Capita GDP Growth in the CE-5 About three-fourths of the difference between growth
4 in the Baltic countries and the CE-5 reflected identifi-
2 able differences in conditions and policies. Relatively
low per capita incomes in Lithuania and Latvia created
0 a sizable catch-up potential, while population growth
was even lower in the Baltics than in the CE-5. The Bal-
–2
tic countries’ export markets—in which Nordic coun-
–4 tries and Russia feature prominently—are growing fast,
providing a substantial leg up from an already-strong
–6 outward orientation. Policies present a mixed picture.
difference
difference
difference
difference
difference
difference
difference
difference
difference
difference
Explained
Explained
Explained
Explained
Explained
Actual
Actual
Actual
Actual
Actual
The Baltics have the advantage in schooling, openness,

and government size, but this was offset by an appar-
Relative to
East Asia
Relative to
Latin
Relative to
Baltic
Relative to
Top Five
Relative to
OECD
ently higher price of investment and slightly weaker
America Countries Countries institutional quality. The models do not explain about
1 percentage points of the recent growth in Estonia
and Latvia, which could reflect a bounce back from the
8 sharp effects of the Russian crisis in 1998 or an under-
Per Capita GDP Growth in the Baltic Countries
estimate of the effects of improvements in the business
6 climate, including in the cost of investment. Without
a clear understanding, however, of the basis for recent
4 strong growth, particularly in Estonia and Latvia, its
durability cannot be taken for granted.
2
0 Trends and Prospects

–2 The CEECs have improved policies in several dimen-
difference
difference
difference
difference
difference
difference
difference
difference
difference
difference
Explained
Explained
Explained
Explained
Explained
Actual
Actual
Actual
Actual
Actual
sions that should contribute to growth potential. Some

of the major efforts were undertaken during the transi-
Relative to Relative to Relative to Relative to Relative to tion from the planned system even as large output losses
East Asia Latin CE-5 Top Five OECD
America Countries occurred. In particular, privatization and the development
of complementary market institutions improved sharply
Source: IMF staff estimates. measures of institutional quality in the early 1990s (Table
5.2). Since then, continued improvements are reflected
in falling relative prices of investment, greater openness,
increased years of schooling, and smaller governments.
But pressures have increased to do more just to main-
tain the same rate of growth. As per capita incomes have
each year. About half of this advantage, however, was increased, the easy catch-up potential has declined.
taken away by slower export market growth. In con- In particular, the possibilities for productivity gains
trast, for the Baltics, lower per capita incomes, lower through more efficient use of existing capital and real-
population growth, and rapid growth in export markets location of resources to higher-productivity growth sec-
(at the same pace as for East Asian economies) resulted tors are increasingly limited. Thus, using the estimation
in a substantial advantage on structural characteristics results and assuming that explanatory variables remain
vis-à-vis East Asia. The CE-5 had a policy disadvan- at their 2004 levels, growth rates of 3–4 percent a
tage relative to East Asia, accounting for lower growth year are predicted in the CE-5 (Figure 5.5). On the
rates by about 1 percentage point a year: East Asia, on same basis, growth rates in the Baltics are predicted to
24

Trends and Prospects
Table 5.2. Evolution of Growth Determinants in the CEECs, 1989–2004
Relative Price Institutional Government Partner

Schooling1 of Investment2 Openness3 Quality4 Size5 Growth6
Czech Rep. 1989 69.38 1.12

1994 2.93 1.38 103.64 78.71 47.00 2.59
1999 2.97 1.28 123.17 75.90 39.20 2.24
2004 3.25 1.23 158.84 76.34 41.40 2.48
Hungary 1989 2.15 1.57 72.85 64.50 1.35
1994 2.28 1.28 67.72 73.04 44.30 2.46
1999 2.43 1.18 108.48 75.79 44.40 2.19
2004 2.59 1.20 113.75 75.77 44.40 2.36
Poland 1989 2.08 1.67 32.74 52.25 0.41
1994 2.21 1.19 45.14 75.13 47.40 2.11
1999 2.32 1.19 58.64 77.93 44.90 2.51
2004 2.43 1.09 89.09 75.03 40.90 2.54
Slovakia 1989 1.36 57.48 69.38 0.67
1994 1.34 118.45 71.42 51.70 2.18
1999 2.93 1.30 128.42 74.58 49.80 2.21
2004 3.05 1.21 162.23 75.32 37.40 2.48
Slovenia 1989 –0.09
1994 3.29 1.03 114.82 3.33
1999 3.67 1.02 109.65 79.03 44.30 2.54
2004 4.00 1.00 120.43 79.40 45.40 2.72
Estonia 1989 –2.18
1994 3.32 1.96 171.47 44.00 2.76
1999 3.43 1.98 158.93 73.16 39.10 3.73
2004 3.65 2.05 164.48 75.17 37.90 3.28
Lithuania 1989 –2.10
1994 3.32 2.24 116.77 34.20 2.33
1999 3.53 1.51 89.80 73.29 37.30 3.87
2004 3.79 1.60 115.57 75.68 32.10 3.42
Latvia 1989 –1.05
1994 3.14 2.77 90.28 37.10 2.76
1999 3.41 2.18 97.97 71.57 36.90 3.38
2004 3.67 2.29 106.06 76.11 35.30 3.15

1Average years of higher education in the population. Hungary and Poland are from the Barro-Lee education data set; for the other countries, estimates
based on secondary and tertiary school enrollments (World Bank, World Development Indicators).
2Ratio of investment deflator to GDP deflator (Penn World Tables (PWT)); last observation is for 2000.
3Sum of exports and imports, relative to GDP, all measured in current prices (PWT; and IMF, World Economic Outlook).
4Composite index (0–100, higher is better) (Political Risk Services, International Country Risk Guide).
5General government revenue in percent of GDP (Eurostat).
6Trade-weighted partner country growth (IMF, World Economic Outlook).
be 5 percent to 6 percent a year, substantially below schooling is more important for productivity growth,
their actual growth in 2000–04, unless the recent over- and that institutional quality increases the catch-up in
performance is in fact based on underlying strengths productivity growth more than the catch-up in capital
not captured in the model. per head. Trade openness, presumably through its effects
Mapping how underlying policies will influence the on competition and specialization, steps up investment
contributions of capital and labor inputs and TFP is and accelerates productivity growth. That said, raising
not straightforward. In fact, there are good reasons to employment ratios to at least the EU average is likely
expect all the policies considered to influence invest- to be a sine qua non for the catch-up. In turn, this will
ment, labor supply and demand, and TFP growth. But require a variety of labor market measures, not explic-
exploratory work, shown in the appendix, suggests that itly included in the empirical exercise.
25

Figure 5.5. CEECs: Predicted Per Capita GDP Growth, 2005–09

(In percent, PPP, annual average)
Actual growth, 2000–04 Global model prediction, 2005–09

9
7.8 7.8
8
7.1
7
5.8
6 5.7
5.3
5
4.3
4.1 3.9 3.9
3.8 3.9
4 3.5 3.5
3.2
3.0
3
2
1
0
Latvia Estonia Lithuania Hungary Slovakia Slovenia Poland Czech Rep.
Sources: Penn World Tables; and IMF staff calculations.
26

VI European Integration: Opportunities for
Growth
ormal membership in the EU and, prospectively, The impetus to growth in the CEECs from foreign
F the euro area critically differentiates the CEECs
from other emerging market countries. An obvious and
savings is already evident. Estimates of the growth
equation (developed in the previous section) includ-
quantifiable benefit comes from large transfers from ing foreign savings bear out other evidence that grow-
the EU—which for the 2000–06 budget period are in ing financial integration in the EU has weakened the
the range of 2 percent to 3 percent of GDP for the constraint of domestic savings on investment—the so-
CEECs. Probably of greater importance will be the called Feldstein-Horioka puzzle.13 The estimates (Box
potential for larger private capital inflows as markets 6.1 and the appendix) bear out heuristic evidence that,
and institutions become more integrated. Against these within the EU, countries with lower per capita income
influences, however, the European market may con- and more rapid growth have tended to make greater use
tinue to grow more slowly than others—a pattern that of foreign savings, which in turn have supported higher
in the past appears to have constrained growth in the growth not only directly but also by increasing the
CE-5 relative to other emerging market country group- speed of convergence (Figure 6.1). That is, foreign sav-
ings. How best to use potential benefits from European ings have been a particularly important spur to growth
integration is key for CEEC growth prospects. in countries with lower per capita incomes.
Perhaps the largest benefit from European integra- Both FDI and other financial flows have contributed
tion will come from the scope provided for easing the to higher growth. Decomposing current account financ-
savings constraint on growth. Not only will consum- ing into FDI and other financial flows in the estimated
ers want to smooth consumption in anticipation of equation shows that FDI has both a direct effect on
future income growth, but also the potential for pro- growth (consistent with evidence in Mody and Murshid,
ductive deployment of foreign savings in the CEECs 2005) and a medium-term effect through increasing the
is large. Lipschitz, Lane, and Mourmouras (2002 and speed of convergence. This seems consistent with the
2005) emphasize that savings rates are generally low special importance of FDI in facilitating privatization
by emerging market standards, while low capital-labor and restructuring during 1995–2002. More recently,
ratios imply high marginal returns to capital.12 Sizable FDI/GDP has fallen in some countries as privatization-
use of foreign savings is already reflected in large cur- related inflows have winded down, while non-FDI flows
rent account deficits (between 8 percent and 12 percent have increased (Figure 6.2). These flows have also have
of GDP in the Baltic countries, for example), but the had a strong and robust effect on the speed of conver-
Lipschitz, Lane, and Mourmouras estimates suggest gence, suggesting that the loosening of financial con-
that capital flows to the CEECs could be even larger. straints and not just the transfer of technology through
Why has this not happened on a larger scale? Currency FDI is playing a role in speeding up the convergence
risk is an obvious hindrance, but Lucas (1990) also process.
points to obstacles to technology transfer and short- Accounting for the interplay between growth and the
comings in institutional quality. As the convergence of use of foreign savings allows a benchmarking of recent
institutions toward EU norms proceeds and the CEECs current account deficits. The growth predictions from
eliminate currency risk by adopting the euro, the use the augmented model are in line with those from the
of foreign savings could be far greater than in other growth regressions in Section V for most of the CEECs.
emerging market countries. Varying degrees of underprediction of the rapid growth
in the Baltics in recent years persists (Figure 6.3). At the
same time, the estimates suggest that the relatively large
12On the assumption that TFP in these countries is 70 percent of
current account deficits in Latvia and Lithuania have
German TFP, they estimate that marginal product of capital in the
CEECs excluding Slovenia is between 1.7 to 10.6 times the marginal
product of capital in Germany. Adjusting their estimates for the
lower TFP ratios in Table 4.2 still leaves most of the CEECs with 13See Blanchard and Giavazzi (2002) for similar results for the 15
marginal products of capital 1.2 to 6.3 times that in Germany. member countries of the EU (henceforth, EU-15) prior to 2004.
27

VI EUROPEAN INTEGRATION: OPPORTUNITIES FOR GROWTH
Box 6.1. International Financial Linkages and Growth

Countries with relatively low income and those growing section are excluded. Higher schooling rates continue to
rapidly can be expected to attract international capital to be related to higher growth; more rapid population growth
take advantage of the higher marginal product of capital is related (though not statistically significantly) to lower
and growth opportunities. This process is modeled in two per capita income growth. Other variables did not change
equations, estimated simultaneously. The current account sufficiently from one year to another to show a material
is a function of the country’s per capita income and GDP influence.
growth rate in the previous year. In addition, a higher The augmented growth regression is estimated on
dependency ratio is predicted to lower national savings EU-25 data from 1975 to 2004, where the new member
and, all else equal, increase the current account deficit. states are included from 1995 onward. We find that cur-
Growth is a function of per capita GDP in the previous rent account deficits support growth and allow for faster
year (allowing, as before, for the possibility of catch-up convergence for low-income countries. Further analysis,
and also for the short-term tendency for mean-reversion). shown in columns 2 to 4 of the table, indicates that this
Because the focus here is on short-term dynamics, some is not simply driven by FDI: non-FDI financial flows also
of the long-term growth determinants used in the previous have a significant beneficial effect.
Financial Integration and Growth Regressions
Dependent Variable: Growth in Real GDP Per Capita
Log of per capita GDP1 –4.76 –3.00 –4.01 –4.09

[4.17]*** [2.75]*** [3.70]*** [3.73]***
Schooling 0.25 0.28 0.29 0.29
[2.59]*** [2.89]*** [3.01]*** [3.01]**
Population growth –0.06 –0.15 –0.13 0.12
[0.22] [0.62] [0.52] [0.52]
Current account deficit 3.68
[3.25]***
Log of per capita GDP*current account deficit –0.39
[3.31]***
Net FDI 0.11 2.42
[3.74]*** [2.70]***
Log of per capita GDP *FDI –0.25
[2.73]***
Non-FDI flows –0.08 3.53
[3.78]*** [5.53]***
Log of per capita GDP *non-FDI flows –0.37
[5.62]***
Number of observations 503 503 503 503
R-squared 0.49 0.47 0.47 0.50
Source: Authors' calculations.

Note: Estimation by three-stage least squares. *, **, and *** indicate significance at 10 percent, 5 percent, and 1 percent levels, respectively.
1The coefficient on income is time-varying; the parameter estimate for 2004 is shown.
been in the range consistent with per capita income; in Rapid growth along with large-scale use of foreign
contrast, in Estonia, the current account deficit—at over savings inevitably produces conditions commonly
12 percent of GDP in 2003 and 2004—was substantially associated with heightened vulnerabilities to financial
higher than the mean prediction (Figure 6.4). In the shocks. Similarities between some of the CEECs and
CE-5, Poland has relied less than predicted on foreign East Asia prior to 1997 underscore the immediacy of
savings, consistent with growth lower than predicted. these concerns (Figure 6.5): current account deficits are
At the other extreme, Hungary’s sizable current account large; credit growth rates (much in foreign currency)
deficit is near the large end of the predicted band, while are rapid; and external debt ratios are high, particularly
actual growth is at the lower end of its predicted band: in the Baltics and Hungary. Reserve cover of short-term
this suggests that inflows have not stimulated short-term debt is, however, generally high, except in the Baltics,
growth, perhaps increasing vulnerability. where Estonia and Lithuania are constrained by cur-
28

European Integration: Opportunities for Growth
Figure 6.1. European Union: Current Account Deficits and the

Speed of Convergence, 1960–20041
1st quartile, current account deficit 2nd quartile, current account deficit
3rd quartile, current account deficit 4th quartile, current account deficit
9
Growth in real GDP per capita
–2
8.5 9 9.5 10 10.5
Log of initial real per capita GDP

Note: Scatterplot observations are grouped by quartiles of the current account deficit, with the smallest
deficits in the lowest quartile.
1
1960–2004 for EU-15 (excluding Luxembourg); 1995–2004 for the new member states (excluding Malta and
Cyprus).
rency boards. Notably also, the financial and public the central focus of bilateral and multilateral surveil-
sectors in the CEECs conform to a rather high stan- lance in these countries—is beyond its scope. But the
dard of transparency and quality of governance (Figure two are closely related: to the extent that faster growth
6.6)—features that should help markets to understand, involves extensive use of foreign savings, signs of vul-
price, and monitor risks more effectively. That said, nerabilities will emerge, but how much of a concern
Lipschitz, Lane, and Mourmouras (2002 and 2005) they are depends in part on how productively foreign
point to discontinuities in the response of risk premia savings are used—that is, how strong the catch-up is.
to changing circumstances of borrowers as a sign of The evidence here suggests that the opportunities for
uneven or insufficient market appraisal of risk. Thus, institutional integration—especially, prospectively, the
they predict that excessive exposure, sudden stops, and elimination of currency risk through the adoption of the
crises are endemic to highly integrated countries with euro—could fundamentally reduce the domestic sav-
large differences in returns on capital. ings constraint for the CEECs and, provided policies to
Critical for the CEECs is whether the opportunities support growth are right, secure a faster catch-up than
for institutional and financial integration with Western is possible, safely, in other emerging market countries.
Europe change the nature of these risks. Since this Judging where the limit to this process is, especially
paper examines the requirements for a rapid catch-up prior to euro adoption, will be the major challenge for
in the CEECs, a full consideration of vulnerabilities— IMF surveillance.
29

Figure 6.2. CEECs: FDI and Non-FDI Financing of Current Account Deficit
(In percent of GDP)
Non-FDI flows FDI flows

15 15
Czech Rep. Estonia
10 10
5 5
0 0
–5 –5
–10 1995 96 97 98 99 2000 01 02 03 04 1995 96 97 98 99 2000 01 02 03 04 –10
15 15
Hungary Latvia
10 10
5 5
0 0
–5 –5
–10 1995 96 97 98 99 2000 01 02 03 04 1995 96 97 98 99 2000 01 02 03 04 –10
15 15
Lithuania Poland
10 10
5 5
0 0
–5 –5
–10 1995 96 97 98 99 2000 01 02 03 04 1995 96 97 98 99 2000 01 02 03 04 –10
15 15
Slovakia Slovenia
10 10
5 5
0 0
–5 –5
–10 1995 96 97 98 99 2000 01 02 03 04 1995 96 97 98 99 2000 01 02 03 04

–10
30

Figure 6.3. CEECs: Predicted Versus Actual Per Capita GDP Growth
(In percent, PPP)
Actual Predicted ±2 standard deviations

12 12
Czech Rep. Hungary
8 8
4 4
0 0
–4 –4
–8 –8
1997 98 99 2000 01 02 03 04 1997 98 99 2000 01 02 03 04
12 12
Poland Slovakia
8 8
4 4
0 0
–4 –4
–8 –8
1997 98 99 2000 01 02 03 04 1997 98 99 2000 01 02 03 04
12 12
Slovenia Estonia
8 8
4 4
0 0
–4 –4
–8 –8
1997 98 99 2000 01 02 03 04 1997 98 99 2000 01 02 03 04
12 12
Latvia Lithuania
8 8
4 4
0 0
–4 –4
–8 –8
1997 98 99 2000 01 02 03 04 1997 98 99 2000 01 02 03 04
31

Figure 6.4. CEECs: Actual Versus Predicted Current Account Balance

(In percent of GDP)
Actual Predicted ±2 standard deviations

2 2
Czech Rep. Hungary
–2 –2
–6 –6
–10 –10
–14 –14
1997 98 99 2000 01 02 03 04 1997 98 99 2000 01 02 03 04
2 2
Poland Slovakia
–2 –2
–6 –6
–10 –10
–14 –14
1997 98 99 2000 01 02 03 04 1997 98 99 2000 01 02 03 04
2 2
Slovenia Estonia
–2 –2
–6 –6
–10 –10
–14 –14
1997 98 99 2000 01 02 03 04 1997 98 99 2000 01 02 03 04
2 2
Latvia Lithuania
–2 –2
–6 –6
–10 –10
–14
1997 98 99 2000 01 02 03 04 1997 98 99 2000 01 02 03 04
32

0
2
4
6
8
10
12
0
20
40
60
80
100
120
Estonia
Latvia
Latvia
Estonia
Hungary
Hungary
Lithuania
External Debt
Slovenia
Thailand (1996)
Slovakia
Slovakia
(In percent of GDP)

(In percent of GDP)
Thailand (1996)
Philippines (1996) Philippines (1996)
Current Account Deficit

Indonesia (1996) Malaysia (1996)
Poland Korea (1996)
Lithuania Czech Rep.
Malaysia (1996) Indonesia (1996)
Slovenia
Baltic countries
Czech Rep.
Selected Vulnerability Indicators
Korea (1996) Poland
Latvia Latvia
Philippines (1996)
CE-5
Indonesia (1996)
Estonia Thailand (1996)
Malaysia (1996)
(In percent)
Philippines (1996)
Figure 6.5. CEECs in 2005 and East Asia in 1996:
Estonia
Thailand (1996)
Lithuania
Lithuania
Hungary
Others
Hungary
Slovakia
Poland
Indonesia (1996)
Slovakia Korea (1996)
Slovenia Poland
Change in Private Credit to GDP
Czech Rep. Slovenia

Reserve Cover of Short-Term Debt

Malaysia (1996) Czech Rep.
(Cumulative over previous three years)
–10
0
50
100
150
200
0
10
20
30
33
Figure 6.6. The CEECs and East Asia: Selected Governance Indicators
Baltic countries CE-5 Others
Voice and Accountability, 2004 Political Stability, 2004

(Index) (Index)
1.5 1.5
1.0 1.0
0.5
0.5
0
0
–0.5
–0.5 –1.0
–1.0 –1.5
Czech Rep.
Czech Rep.
Hungary
Poland
Estonia
Slovenia
Lithuania
Latvia
Korea
Thailand
Philippines
Malaysia
Indonesia
Slovenia
Latvia
Estonia
Lithuania
Hungary
Korea
Malaysia
Poland
Thailand
Philippines
Indonesia
Slovakia
Slovakia
Rule of Law, 2004 Regulatory Quality, 2004
(Index) (Index)
1.5 2.0
1.0 1.5
1.0
0.5
0.5
0
0
–0.5 –0.5
–1.0 –1.0
Czech Rep.
Czech Rep.
Slovenia
Estonia
Hungary
Korea
Lithuania
Malaysia
Poland
Latvia
Thailand
Philippines
Indonesia
Estonia
Hungary
Lithuania
Latvia
Slovenia
Korea
Poland
Malaysia
Thailand
Philippines
Indonesia
Slovakia
Slovakia
Financial Sector Regulation and Share of Foreign-Owned Banks in Total

Supervision, 2003 Bank Assets, 2003
(Index) (In percent)
25 Overall supervisory power
100
20 Capital regulatory index 80
15 60
10 40
5 20
0 0
Czech Rep.
Czech Rep.
Slovenia
Latvia
Hungary
Estonia
Indonesia
Korea
Lithuania
Philippines
Poland
Thailand
Malaysia
Estonia
Hungary
Lithuania
Poland
Latvia
Korea
Slovenia
Malaysia
Philippines
Indonesia
Thailand
Slovakia
Slovakia
Sources: World Bank Governance Database (Kaufmann, Kraay, and Mastruzzi, 2005); and World Bank Financial
Regulation/Supervision Database (Barth, Caprio, and Levine, 2006).
Note: Higher index numbers indicate better governance.
34

VII Implications for IMF Surveillance
medium- to long-term perspective on growth will • Restrictions on dismissals and on temporary

A be a necessary complement to the short-term con-
cerns prominent in surveillance. The CEECs, having
employment, while not standouts among OECD
countries, are still sufficiently cumbersome in some
emerged from the low-growth era of central planning, countries as to limit the growth of labor demand.
have in EU membership a unique opportunity to catch
• Fiscal disincentives to labor supply and demand
up to advanced country levels. But even when pursued
are substantial in some CEECs. Payments to inac-
with focus and determination, catching up will be a
tive persons—disability benefits, social assistance,
long-drawn process. Surveillance must therefore help
and, to a lesser extent, unemployment benefits—are
guide a series of reinforcing measures that cumulate
significant disincentives to job search and excessive
in sustained growth, while containing vulnerabilities
burdens on government finances. The tax wedge
inherent in the catching-up process. Ultimately, growth
(personal income tax and social security contribu-
mitigates vulnerabilities.
tions) is high in some CEECs. Joint action on these
The review of growth prospects in the CEECs sug-
problems can improve incentives to work without
gests several directions for this aspect of surveillance.
worsening fiscal accounts.
Broadly, these are increasing employment, fostering
productivity growth, and managing risks inherent in • Regional mobility has been hampered by social
greater use of foreign savings, including through euro transfers, low costs of living in high-unemployment
adoption. Although mapping the variables identified areas, and rigidities in the housing, especially in the
in this study to specific policies is not straightforward, rental, markets.
several directions for IMF advice are indicated: the • Skill mismatches seem to be a significant problem
particular measures relevant to a country will reflect its in some CEECs, indicating an important role for
history and institutional structure. better tailoring educational systems to labor market
needs.
Labor Absorption
Closing the Productivity Gap
The spread of gainful employment will be a central
challenge. After employment rates fell sharply dur- Raising CEEC productivity to EU levels will depend
ing transition, they have at best stabilized at rates that on raising capital-labor ratios through high investment
are low relative to other emerging market countries. It and improving the efficiency of resource use. The anal-
seems likely that rapid structural change has created ysis in this paper identifies several influences on such
unusually high structural inactivity that may reverse as objectives that are directly and indirectly related to
the pace of job destruction slows. Moreover, by some policies. Some, such as improving education, are rather
conventional measures (such as employment protection clearly outside the scope of IMF surveillance. Oth-
legislation, unemployment benefits, and the degree of ers, such as openness to trade and keeping the relative
unionization) labor markets in the CEECs are not nota- cost of investment low, are ones on which the CEECs
bly inflexible. Nevertheless, achieving the percentage already score rather well. However, three—sustaining
point a year increase envisaged in the growth scenarios low inflation, containing the size of government, and
in Section IV will be a major hurdle. OECD (2004), improving institutions—are squarely within the man-
Schiff and others (2006), and Choueiri (2005) iden- date of IMF surveillance.
tify measures that will be an integral part of growth- The CEECs have all achieved inflation rates well
enhancing policies. below thresholds identified as harmful for growth
Broadly, and it must be recognized that labor market prospects. Low inflation expectations should provide
characteristics and problems vary widely, these studies support for keeping this record intact. Nevertheless,
identify a few major priorities. especially for the countries that are most successful in
35

VII IMPLICATIONS FOR IMF SURVEILLANCE
Figure 7.1. Fiscal Balance and Risk Ratings in Emerging

Market Economies, 1990–2002
70
Korea
Malaysia
Average Institutional Investor rating
China Thailand
60
Hungary Chile
Israel Mexico
50 India South Africa Colombia
Poland Indonesia
Morocco Uruguay
Philippines
40
Egypt Argentina Venezuela Brazil
Jordan Panama
Russia Peru
30
Pakistan
Ecuador
Côte d’Ivoire Ukraine
Nigeria
20
–8 –6 –4 –2 0 2
Average fiscal balance/GDP
Sources: Institutional Investor; IMF, World Economic Outlook, September 2003 public debt data set; and
IMF staff calculations.
achieving a rapid catch-up, price pressures can emerge will depend importantly on initial debt ratios, the his-
quickly. A key role of surveillance is to anticipate any tory of inflation, and the time-specific appetite for risk
pickup in inflation and help tailor monetary, fiscal, and in local and global financial markets. Indeed, insofar
wage policies to curtailing it. as fiscal deficits are often the source of currency crises
Arriving at a size of government that supports with attendant output costs, fiscal sustainability must
growth prospects is likely to be a bigger challenge. The be at the core of a sound growth strategy. The correla-
results in this study suggest that larger governments are tion between risk premia on interest rates and the size
associated with slower growth. This effect can work of deficits is a manifestation of this constraint (Figure
through various inefficiencies: a heavy tax burden that 7.1).15 But the fiscal stance is likely to play a broader
produces disincentives to work or invest, or spending role in the CEECs—restraining the pace of demand
that runs ahead of government’s ability to deliver public growth in countries that get the underlying conditions
goods and services efficiently. Thus, notwithstanding for rapid convergence right. For some CEECs already,
evidence that governments in some advanced countries fiscal balances that are substantially stronger than con-
can effectively supply public goods on a large scale, it siderations of debt sustainability alone would require
seems likely that the CEECs, with their legacy of inef- have become necessary to contain overheating pres-
ficiencies associated with central planning, will benefit sures resulting from large capital inflows, currency
from maintaining or achieving relatively small govern- appreciation, and rapid bank credit growth.
ments. And because infrastructure needs to support A third broad issue is to nurture institutions—many
growth are likely to be large, the focus will need to be at the macroeconomic level—that underpin growth. The
on constraining current spending. measure of institutional development used in this study
A more difficult question is how the size of fiscal is broad—a composite of measures of government sta-
deficits influences growth. In general, little evidence bility, democratic accountability, law and order, quality
exists of a robust direct link between budget deficits, on of bureaucracy, and corruption in government. As such
the one hand, and growth, investment, or inflation, on it indicates the importance of institutions for growth,
the other.14 However, this may reflect the fact that even
thresholds beyond which deficits might affect growth 15Consistent with this risk interpretation, Adam and Bevan (2005)
find that deficits hurt growth only if they exceed 1.5 percent of GDP.
Moreover, larger deficits are more harmful to growth the higher the
14See, for example, Harberger (2003) and Edwards (2003). public debt.
36

Euro Adoption
Figure 7.2. CEECs: Foreign Currency Government Bond Spreads

(In basis points)
300
250
Czech Rep.
Estonia
200 Hungary
Latvia
Lithuania
150 Poland
Slovakia
Slovenia
100
50
0
2000 2001 2002 2003 2004 2005
Source: Reuters.
but does not point to specific measures that are par- a range consistent with their strong growth rates. But
ticularly important. That said, other literature, together exceptions exist, and judgments even in the apparently
with the findings of Article IV consultations, points to clearer-cut cases can be subject to considerable uncer-
five institutional areas with significant macroeconomic tainty. Indeed, the CEECs are likely to exemplify the
dimensions that should be the focus of structural policy tension between the role of large inflows in supporting
efforts: financial supervision and prudential control, a rapid catch-up and their contribution to vulnerabili-
judicial institutions and efficient protection of property ties stemming from rising external debt/GDP, strong
rights, the scope for corruption, costs of doing business, appreciation, rapid credit growth, and balance sheet
and product market competition. mismatches. It will be important to balance acceptance
of large changes that accompany rapid catch-up with
vigilance in identifying when such changes involve
Use of Foreign Savings excessive vulnerabilities.
Use of foreign savings will continue to feature prom-

inently in surveillance. The results from this study Euro Adoption
point to the importance of recognizing the role of for-
eign savings in contributing to growth and avoiding A central question for the region is how the adoption
rules of thumb on “safe” maximum current account of the euro could affect growth prospects and, spe-
deficits. The lower-income, rapidly growing economies cifically, the risks in large-scale use of foreign savings.
have run large current account deficits and the associ- As small open economies with sufficient flexibility to
ated capital flows have contributed to the strength of absorb asymmetric shocks, the CEECs should benefit
growth. Yet obviously large net inflows, alongside siz- considerably from adopting a major international cur-
able reductions in country risk premia (Figure 7.2), and rency. Gains from euro adoption fall into three cat-
rapid increases in foreign-exchange-denominated bank egories: increased trade, greater policy discipline, and
credit, raise concerns about whether financial markets lower risk premia and the related scope for larger use
are adequately assessing risks. of foreign savings.
A key issue will therefore be to discern when large Considerable empirical work suggests that joining
current account deficits are constructively facilitating a currency union raises overall trade and, presumably
the catch-up and when they pose undue vulnerabilities. through efficiency gains from greater competition, output
The evidence in this study suggests that substantial growth (Schadler and others, 2005). These studies find
use of foreign savings in most of the CEECs is within that upon joining a currency union, countries increase
37

VII IMPLICATIONS FOR IMF SURVEILLANCE
trade with other countries in the union while trade with contrast, other countries have fallen victim to short-
countries outside the union does not decrease—and may term incentives to meet the Maastricht criteria, and,
even increase. Gravity models of Economic and Mone- without addressing underlying fiscal and structural
tary Union suggest gains of 6–15 percent, after only five problems, have ended up with overvalued parities add-
years of its initiation (Faruqee, 2004). One controversy ing to the negative effects of rigidities on growth.
about these findings concerns whether they adequately The reduction in risk premia—in the run-up to and
differentiate trade gains owing to euro adoption from following the introduction of the euro—is a third poten-
those owing to ongoing economic integration with Europe tially strong advantage for growth. Most CEECs have
(Gomes and others, 2004). Faruqee finds, however, that already seen their risk premia drop to levels that are
gains from euro adoption differed across countries, with among the lowest in emerging market countries. Further
the gains being largest where existing international pro- gains, while not insignificant, will therefore be small.
duction networks were already in place. Of perhaps greater importance for growth will be the
A dilemma for the CE-5 will be balancing the ben- scope for increased use of foreign savings as financial
efits and costs of diversifying trade. The findings in integration increases and the risks—particularly those
this paper suggest that increased trade and openness to associated with foreign exchange exposure— diminish.
trade—owing in no small part to EU accession—have In principle, this would allow a delinking of domestic
been a major impetus to growth in the CEECs. Those savings and investment beyond that already seen in
growing trade ties have also enhanced the cyclical con- some of the CEECs.
vergence of the CE-5 in particular with the euro area— The timing and conditions of euro adoption are likely
a key optimal currency area criterion. Yet the strength to have major effects on growth prospects, especially in
of the CE-5 trade ties with the relatively slow-growing countries that now have significant exchange rate flex-
euro area core has also meant that the direct benefit ibility. The experiences of current euro area members
from trade has been less in the CE-5 than in the Baltics point to three critical steps prior to joining the euro area
with their orientation toward the faster-growing Nordic (Schadler and others, 2005). First, choosing a conver-
countries and Russia. Geography and history may play sion rate compatible with strong export performance is
such strong roles that significant diversification would crucial. While upward adjustments through inflation
be difficult, but the advantages of closer integration are not particularly difficult, downward adjustments
with the euro area core versus greater trade diversifica- would take a major toll even in the most flexible econo-
tion to capture benefits from faster-growing markets mies. Second, entering from a position of sound mac-
should be considered. roeconomic policies—particularly with fiscal deficit
The potential for increased policy discipline as a and debt ratios well below the Maastricht limits of 3
result of joining the euro area is uncertain. By provid- percent and 60 percent of GDP, respectively—will pro-
ing an external anchor, the prospect of euro adoption tect against the need for procyclical fiscal policies and
and, subsequently, actual membership can foster fis- difficulties in the event of financial shocks. Third, bol-
cal discipline and spur structural reforms to increase stering mechanisms for economic flexibility will help
economic flexibility. Although causality is difficult to secure the ability to adjust to shocks and respond to
ascertain, the boost to growth for some current euro opportunities from any changes in comparative advan-
area members has been in some cases impressive. In tage within the euro area.
38

Appendix Growth Regressions and Data
Description
Panel Growth Regressions Following Barro and Sala-i-Martin (2004), we use

the seemingly unrelated regression procedure to esti-
The analysis of growth performance covered a broad mate the growth model. This procedure allows for
range of countries over the period 1984–2004. While, country random effects that are correlated over time;
in principle, the regressions attempted to cover the that is, it estimates each five-year period as a cross
set of developed and developing economies listed in section but controls for the possibility that the residu-
Table A1, gaps in the data reduced the number actually als in each cross-section regression are correlated,
included in the regression by an extent that depended on as they are likely to be in these growth regressions.
the specification. In particular, because more data were Our results, however, are robust to using different
available for recent years, the sample size increased econometric specifications, including simple random
over time. The dependent variable in the regressions effects and cluster ordinary least squares where stan-
are growth rates of real per capita GDP in PPP terms, dard errors are adjusted for within-group correlation.
calculated over nonoverlapping five-year periods (e.g., As an additional robustness check, which also sheds
2000–04, 1995–99, 1990–94), providing time-series as substantive light on differences across country groups,
well as cross-sectional variation. the regressions were run on different subsamples—
Variables used for explaining growth were influenced developing countries, emerging market countries, and
by recent findings on the robustness of growth determi- advanced economies—to assess whether parameter
nants and the context of the CEECs. The robustness of estimates change systematically across the groups.
growth influences was judged primarily by the results Regressions for different country groups (reported
in SDM (2004). In addition to initial income per capita, in Table A2) illustrate variations across the groups
other controls suggested by neoclassical growth models using a core set of explanatory variables. These vari-
were population growth, the price of investment, and ables behave directionally the same way across country
human capital accumulation (proxied by the average groups, but the size and significance of coefficients are
years of higher education). As discussed in the main quite different. Thus, there is support both for com-
text, additional controls in the benchmark regression monality of growth drivers and for the dissimilarity of
include partner country growth, openness to trade, the their potency. Of interest is the finding on variations
size of government (proxied by tax revenues to GDP), in conditional convergence across country groups. In
and a measure of institutional quality. Further details the group of non-emerging-market developing coun-
on the construction of these variables can be found in tries, even conditional convergence seems to be absent.
the data description below. In contrast, emerging and advanced economies are
One novel feature of the growth regressions is the characterized by both absolute and conditional conver-
inclusion of an interaction term between institutional gence. For this reason, when we use the global sample
quality and per capita income. Background studies for for analyzing growth, it is important to make allowance
this paper found that institutional quality affects not for variations in convergence rates. Other growth deter-
only the steady-state level of income but also the speed minants similarly operate with differing force across
at which countries converge to the steady state. This country groups.
can be seen in Figure 5.1, which groups observations The two benchmark regressions are presented in Table
into quartiles of institutional quality and plots the A3. So as not to introduce a proliferation of results, we
best-fit lines through each quartile. Better institutional worked toward two “benchmark” regressions: a suit-
quality is associated not only with higher steady-state ably modified “global” regression, which deals with
incomes (reflected in the best-fit lines shifting up) but variations in convergence rates across countries, and an
also with a higher speed of convergence (reflected advanced economy–emerging market regression, which
in the steeper slopes, so that countries with superior drops developing countries to ensure that the results are
institutions move more quickly toward their steady- not being driven solely by low-income countries. As we
state income levels). report below, both regressions give qualitatively similar
39

APPENDIX
Table A1. Global Sample of Economies
Albania Guinea Panama

Algeria Guinea-Bissau Papua New Guinea
Angola Haiti Paraguay
Argentina Honduras Peru
Armenia Hong Kong SAR Philippines
Australia Hungary Poland
Austria India Portugal
Azerbaijan Indonesia Romania
Bangladesh Iran, I.R. of Russia
Belarus Ireland Saudi Arabia
Belgium Israel Senegal
Bolivia Italy Serbia and Montenegro
Botswana Jamaica Sierra Leone
Brazil Japan Singapore
Bulgaria Jordan Slovakia
Burkina Faso Kazakhstan Slovenia
Cameroon Kenya South Africa
Canada Korea Spain
Chile Kuwait Sri Lanka
China Latvia Sudan
Colombia Lebanon Sweden
Congo, Dem. Rep. of Libya Switzerland
Congo, Rep. of Lithuania Syrian Arab Rep.
Costa Rica Madagascar Taiwan Province of China
Croatia Malawi Tanzania
Czech Republic Malaysia Thailand
Côte d’Ivoire Mali Togo
Denmark Mexico Trinidad and Tobago
Dominican Rep. Moldova Tunisia
Ecuador Mongolia Turkey
Egypt Morocco Uganda
El Salvador Mozambique Ukraine
Estonia Myanmar United Arab Emirates
Ethiopia Namibia United Kingdom
Finland Netherlands United States
France New Zealand Uruguay
Gabon Nicaragua República Bolivariana
Gambia,The Niger de Venezuela
Germany Nigeria Vietnam
Ghana Norway Yemen
Greece Oman Zambia
Guatemala Pakistan Zimbabwe
results in assessing the performance of the CEECs rela- sion implies that one cannot interpret the coefficient on
tive to their peers. However, the results from the global (uninteracted) initial income as an indicator of condi-
sample do a somewhat better job of matching actual tional convergence; the convergence parameter in this
and predicted growth rates. Following the discussion in regression is given by B0 + B1 • InstitutionalQuality,
the main text, explanatory variables are placed into two where B1 is the coefficient on the interaction term. The
groups, those that are beyond the short-term control of negative sign on B1 implies that as institutional quality
policymakers and those that are potentially influenced improves, convergence speeds increase, supporting the
by policy. The coefficient estimates are all correctly scatterplot in Figure 5.1.
signed, are of plausible magnitudes, and are all signifi- The same regressions can be run using TFP growth
cant with the exception of the relative price of invest- and capital per capita growth as the dependent vari-
ment in the global regression and the schooling variable ables, enabling analysis of the channels through which
in the advanced economy–emerging market subsample. these variables affect growth. These growth accounting
The presence of the interaction term between institu- regressions, whose results are described in the main
tional quality and initial income in the global regres- text, can be found in Table A4.
40

Appendix
Table A2. Growth Regressions with Core Controls, Using Different Country Samples
Emerging Advanced and

Global
___________________ Developing Country ___________________
___________________ Market Country Emerging Market Country
______________________
Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic
Log of per capita GDP –0.43 (2.40) –0.16 (0.54) –1.71 (6.10) –1.71 (7.54)
Schooling 0.41 (3.22) 0.82 (2.45) 1.27 (5.87) 0.34 (2.99)
Population growth –0.34 (5.34) –0.28 (3.13) –0.68 (4.55) –0.68 (6.02)
Relative price of investment –0.59 (3.80) –0.30 (1.58) –1.18 (3.79) –1.09 (3.88)
Dummy, 2000–04 6.81 (4.47) 3.73 (1.65) 17.33 (6.65) 19.36 (8.87)
Dummy, 1995–99 6.12 (4.05) 2.93 (1.31) 16.24 (6.22) 18.87 (8.64)
Dummy, 1990–94 5.23 (3.38) 1.10 (0.48) 18.05 (6.89) 18.90 (8.60)
Dummy, 1985–89 5.81 (3.82) 1.85 (0.81) 17.49 (6.79) 19.22 (8.88)
Dummy, 1980–84 5.28 (3.42) 1.62 (0.69) 17.58 (6.79) 18.44 (8.48)
Dummy, 1975–79 6.55 (4.22) 3.09 (1.32) 19.20 (7.49) 19.54 (8.97)
Dummy, 1970–74 7.47 (4.90) 4.14 (1.80) 19.02 (7.56) 20.15 (9.40)
Dummy, 1965–69 7.41 (4.92) 3.68 (1.62) 19.19 (7.89) 20.32 (9.62)
Number of observations 740 356 218 384

Note: Dependent variable is five-year growth in real GDP per capita (PPP). Estimation method is seemingly unrelated regression.
Table A3. Growth Regression Estimates
Advanced and Emerging

Global Sample
_______________________ Market Country Sample
_______________________
Coefficient t-statistic Coefficient t-statistic
Log of per capita GDP 1.36 (1.89) –2.27 (6.34)

Population growth –1.46 (8.94) –1.27 (7.42)
Partner country growth 0.62 (3.39) 0.61 (3.24)
Relative price of investment goods –0.22 (0.84) –0.75 (2.41)
Schooling 0.45 (2.53) 0.20 (1.40)
Openness ratio 0.01 (3.01) 0.01 (3.85)
Government taxation ratio –0.05 (2.47) –0.02 (1.20)
Institutional quality 0.41 (4.07) 0.03 (1.88)
Institutional quality * log of per capita GDP –0.04 (3.86)
Dummy, 2000–04 –10.66 (1.69) 20.93 (6.74)
Dummy, 1995–99 –11.32 (1.80) 20.31 (6.50)
Dummy, 1990–94 –10.33 (1.65) 20.96 (6.72)
Dummy, 1985–89 –11.12 (1.78) 20.51 (6.50)
Number of observations 96, 84, 52, 56 58, 51, 41, 41
R-squared 0.47, 0.02, 0.3, 0.37 0.58, –0.17, 0.36, 0.36

Note:The dependent variables are the growth rates of per capita GDP for the periods 2000–04, 1995–99, 1990–94, and 1985–89. Estimation method is
seemingly unrelated regression.
Benchmark Models: Growth • Both models predict well. The relative rank-
Predictions ings of the country groups are well matched:
high-growth countries or regions have high
Three general points emerge when comparing predicted growths and vice versa. This can be
the benchmark model predictions and actual growth seen in Figure A1, which reports the results
outcomes during the period 2000–04. for regional country groups and for the top
41

42
APPENDIX
Table A4. Growth Accounting Regressions
Global Sample
___________________________________________________________ Advanced and Emerging Market Country Sample
_________________________________________________________
GDP per capita Capital per capita TFP
___________________ ___________________ __________________ __________________GDP per capita Capital per capita
__________________ TFP
__________________
Coefficient t-statistics Coefficient t-statistics Coefficient t-statistics Coefficient t-statistics Coefficient t-statistics Coefficient t-statistics
Log of per capita GDP 1.36 (1.89) 1.08 (1.28) 1.55 (2.14) –2.27 (6.34) –2.39 (6.92) –1.43 (4.55)
Population growth –1.46 (8.94) –0.87 (4.89) –1.09 (7.87) –1.27 (7.42) –0.88 (4.87) –0.99 (6.94)
Partner country growth 0.62 (3.39) 0.53 (2.72) 0.62 (3.78) 0.61 (3.24) 0.64 (3.31) 0.59 (3.44)
Schooling 0.45 (2.53) 0.13 (0.75) 0.46 (3.39) –0.75 (2.41) 0.01 (0.08) 0.29 (2.31)
Relative price of
investment –0.22 (0.84) –0.26 (1.02) 0.11 (0.58) 0.20 (1.40) –0.94 (2.84) –0.28 (1.08)
Openness ratio 0.009 (3.01) 0.009 (2.99) 0.009 (4.08) 0.010 (3.85) 0.009 (3.44) 0.009 (3.92)
Government taxation
ratio –0.05 (2.47) –0.08 (3.92) –0.02 (0.99) –0.02 (1.20) –0.05 (2.45) –0.008 (0.46)
Institutional quality 0.41 (4.07) 0.39 (3.26) 0.32 (3.19) 0.03 (1.88) 0.08 (5.18) –0.01 (0.75)
Institutions * log of
per capita GDP –0.04 (3.86) –0.03 (2.60) –0.04 (3.43)
Dummy, 2000–04 –10.66 (1.69) –11.21 (1.45) –12.68 (1.92) 20.93 (6.74) 19.69 (6.44) 13.92 (5.21)
Dummy, 1995–99 –11.32 (1.80) –11.28 (1.46) –13.03 (1.97) 20.31 (6.50) 19.56 (6.38) 13.35 (4.97)
Dummy, 1990–94 –10.33 (1.65) –10.54 (1.38) –12.51 (1.91) 20.96 (6.72) 20.21 (6.59) 13.76 (5.13)
Dummy, 1985–89 –11.12 (1.78) –11.54 (1.51) –12.98 (1.98) 20.51 (6.50) 18.82 (6.09) 13.63 (5.01)
Number of observations 288 255 255 191 187 187

Appendix
Figure A1. Emerging Market Countries: Actual and Predicted Per Capita GDP Growth, 2000–04
Global Model Advanced and Emerging Market Country Model

9 9
8 7.6 7.6 8
7 6.6 6.4
7
6.4
6 5.7 6
5.4
5 4.5 5
4.0
4 3.6 3.6 3.7 3.6 3.6 3.7 3.7 4
3 3
2.2
2 1.8 2
1.0 1.0
1 1
0 0
Baltic CE-5 East Asia Latin Top Five Baltic CE-5 East Asia Latin Top Five
Countries America Countries America
Figure A2. CEECs: Actual and Predicted Per Capita GDP Growth, 2000–04

Global Model Advanced and Emerging Market Country Model
9 9
8 7.8 7.8 7.8 7.8 8
7.1 7.1
6.9
7 6.5
7
6.2
6.0
6 5.8 6
5.4
5 5
4.3 4.3 4.3
4.1
4 3.8 3.7
3.5 3.3
3.7 3.8 3.8 4
3.4 3.5 3.5 3.3
3.2 3.2 3.2
3.0 3.0
3 3
2 2
1 1
0 0
ep.
ep.
ia
ia
ia
ia
a
a
ia
nia
nia
y
ry
and
and
tvi
ani
a ni
r
vak
vak
ven
ven
tv
nga
nga
hR
hR
to
to
La
La
hu
hu
Pol
Pol
Es
Es
Slo
Slo
Slo
Slo
Hu
Hu
Lit
Lit
c
c
Cze
Cze
43

APPENDIX
five emerging market performers excluding the Decomposition of Growth Differences

Baltics.
The growth regressions can provide useful decom-
• Predictions are particularly close in absolute, or positions of the importance of various factors in
cardinal, terms in the mid-ranges of growth rates explaining differences in growth rates across regions
and diverge at the two extreme ends. At the high or countries (Tables A5 and A6). The decomposition
end, the Baltics and the top five performers are of growth predictions when no interaction terms are
predicted to have lower growth rates than they present is straightforward: it is given by (suppressing
actually achieved. In contrast, Latin America, subscripts):
which achieved particular low average per capita
growth during this period should, the models say, ŷ – yˆR = B'(#–#R),
have achieved higher growth. Thus, it appears
as if extreme growth rates are the outcomes of where the superscript R denotes the reference country.
special circumstances not easily captured by In the benchmark model, the effects of the interac-
such growth models. Countries with very rapid tion between initial income per capita and institutional
growth already have the potential to grow fast, as quality needs to be reallocated into the part that is due
implied by their high predicted growth rates, but, to differences in initial income and the part that is due to
in addition, are positioned to benefit from posi- differences in institutional quality. This is done as follows.
tive surprises. In contrast, countries with lower Predicted growth for a country/region and the reference
growth potential are the ones most hurt by nega- country/region are given by
tive growth surprises.
ŷ t = B0yt–1+B1It–1+B2yt–1It–1+B'#t–1
• Finally, while both models do well, the “global”
model outperforms slightly with somewhat bet- ŷ tR = B0yRt–1+B1IRt–1+B2yRt–1IRt–1+B'#Rt–1.
ter predictions. While it is difficult to be precise
in assessing the source of this difference, there
Subtracting the second equation from the first gives
is probably one substantive reason and another
technical reason. Substantively, the global model
allows for differing speeds of convergence. While ŷ t – ŷ tR = B0 (yt–1– yRt–1) +B1(It–1– IRt–1)
the speeds of conditional convergence in emerg- +B'(#t–1–#Rt–1)+ B2 (yt–1It–1– yRt–1IRt–1).
ing market countries and advanced economies
are close, it appears that advanced countries, with To reallocate the second term to differences in ini-
their better institutions, may converge slightly tial income and institutional quality, add and subtract
faster. We are not able to pick up that nuance B2 It–1yRt–1 and rearrange this with the last term above
in the smaller sample. This leads to the second to get:
technical reason for the difference. In the smaller
sample, the variation in explanatory variables is
ŷ t – ŷ tR = B0 (yt–1– yRt–1)+ B1(It–1– IRt–1)+B'(#t–1–#Rt–1)
smaller, making it harder to achieve estimates
with great precision. + B2 (y t–1 It–1 – y Rt–1 I Rt–1)+ B2 It–1y Rt–1– B2 It–1y Rt–1
= B0 (yt–1– yRt–1)+ B1(It–1 – IRt–1)+ B'(#t–1– #Rt–1)
The models are almost spot-on in predicting the + B2 It–1(yt–1– yRt–1)+ B2yRt–1(It–1– IRt–1).
average growth rates in the CE-5, but underpredict
growth in the Baltics (Figure A2). For the CE-5, both Finally, combine terms to get
the actual and predicted growth rates are around 3
percent a year. Once again, the predicted ranks for ŷ t – ŷ tR = (B0 +B2 It–1)(yt–1– yRt–1)+ (B1+B2yRt–1)
country growth rates line up with the actual perfor-
mance and in no case is the difference between actual (It–1– IRt–1)+B'(#t–1–#Rt–1).
and predicted growth rates more than percentage
Note that one can also perform the decomposition
point. With respect to the Baltics, which achieved
an annual average growth rate of 7 percent over by adding and subtracting B2 IRt–1yt–1, which would give
this period, the global model predicts a 6 percent a similar formula:
growth rate and the advanced economy–emerging
market model predicts a little over 5 percent. Once ŷ t – ŷ tR = (B0 +B2 IRt–1)(yt–1– yRt–1) + (B1 +B2yt–1)(It–1– IRt–1)
again, looking at the individual countries, growth + B'(#t–1–#Rt–1).
rates are underpredicted, but less so by the global
model, which comes close to matching Lithuania’s This decomposition allocates the cross term, B2(yt–1–
actual achievement. yRt–1)(It–1–IRt–1), to differences due to initial income, while
44

Table A5. CE-5: Decomposition of Growth Differences
CE-5 Performance (2000–04) Relative to

____________________________________________________________________________________________
Top five emerging OECD
East Asia Latin America Baltic countries market countries countries
Difference in GDP per capita growth to

be explained –0.1 2.7 –4.0 –2.9 1.4
Advanced Advanced Advanced Advanced Advanced

and emerging and emerging and emerging and emerging and emerging
market market market market market
Global country Global country Global country Global country Global country
regression regression regression regression regression regression regression regression regression regression
Difference explained by “exogenous” variables

Log of per capita GDP –0.45 –0.52 –1.19 –1.49 –0.79 –0.93 –1.14 –1.44 1.06 1.14
Population growth 1.86 1.62 2.28 1.98 –1.00 –0.87 0.24 0.21 0.90 0.78
Partner country growth –0.87 –0.86 –0.18 –0.18 –0.82 –0.80 –0.63 –0.61 –0.21 –0.20
Subtotal 0.54 0.24 0.90 0.31 –2.61 –2.59 –1.53 –1.85 1.76 1.72
Difference explained by “policy-influenced” variables
Schooling –0.20 –0.09 0.40 0.18 –0.27 –0.12 –0.29 –0.13 –0.55 –0.24
Relative price of investment –0.01 –0.02 0.17 0.58 0.15 0.52 0.10 0.34 –0.05 –0.16
Openness –0.32 –0.34 0.19 0.20 –0.09 –0.10 0.33 0.36 0.22 0.24
Institutional quality 0.02 0.10 0.14 0.31 0.03 0.12 0.15 0.34 0.04 –0.11
Tax revenue/GDP –0.57 –0.25 –0.44 –0.20 –0.18 –0.08 –0.53 –0.24 0.03 0.01
Subtotal –1.08 –0.60 0.45 1.07 –0.35 0.35 –0.24 0.67 –0.30 –0.26
Total explained difference –0.54 –0.36 1.35 1.38 –2.96 –2.25 –1.77 –1.17 1.45 1.47
Appendix
45

46
APPENDIX
Table A6. Baltic Countries: Decomposition of Growth Differences
Baltic Countries’ Performance (2000–04) Relative to

____________________________________________________________________________________________
Top five emerging OECD
East Asia Latin America CE-5 market countries countries
Difference in GDP per capita growth to 3.9 6.7 4.0 1.2 5.4
be explained
Advanced Advanced Advanced Advanced Advanced
and emerging and emerging and emerging and emerging and emerging
market market market market market
Global country Global country Global country Global country Global country
regression regression regression regression regression regression regression regression regression regression
Difference explained by “exogenous” variables

Log of per capita GDP 0.33 0.40 –0.43 –0.57 0.79 0.93 –0.39 –0.51 1.84 2.07
Population growth 2.86 2.48 3.27 2.84 1.00 0.87 1.24 1.07 1.90 1.65
Partner country growth –0.05 –0.05 0.64 0.63 0.82 0.80 0.19 0.19 0.61 0.60
Subtotal 3.14 2.83 3.48 2.90 2.61 2.59 1.04 0.75 4.36 4.32
Difference explained by “policy-influenced” variables
Schooling 0.07 0.03 0.67 0.29 0.27 0.12 –0.02 –0.01 –0.28 –0.12
Relative price of investment –0.15 –0.54 0.02 0.06 –0.15 –0.52 –0.05 –0.18 –0.19 –0.68
Openness –0.23 –0.24 0.28 0.30 0.09 0.10 0.42 0.45 0.31 0.33
Institutional quality –0.01 –0.02 0.14 0.19 –0.03 –0.12 0.16 0.22 0.02 –0.23
Tax revenue/GDP –0.39 –0.17 –0.27 –0.12 0.18 0.08 –0.36 –0.16 0.20 0.09
Subtotal –0.72 –0.95 0.84 0.72 0.35 –0.35 0.15 0.33 0.06 –0.61
Total explained difference 2.42 1.89 4.32 3.62 2.96 2.25 1.20 1.07 4.42 3.71

Appendix
the first decomposition allocates it to differences due to example, by Barro and Sala-i-Martin (2004). In an
institutional quality. Since the cross-term is due to both open economy, if factors are fully mobile and the tech-
types of differences, this choice is arbitrary. nology across countries does not differ, factor returns
A final alternative would be to “split the differ- should equalize almost instantaneously, achieving
ence” and attribute equal parts of the cross term to income convergence. If, however, some forms of capi-
initial income differences and institutional quality tal (e.g., human capital) provide unacceptable security
differences: for loans, then the extent of foreign debt will be limited
by quantity of physical capital that can serve as col-
ŷ t – ŷ tR = (B0 +B2 (It–1+IRt–1)/2)(yt–1 –yRt–1) lateral. In such a model, Barro and Sala-i-Martin write,
“the opportunity to borrow on the world credit market
+(B1 +B2 (yt–1+yRt–1)/2)(It–1–IRt –1) . . . will turn out to affect the speed of convergence”
+B'(#t–1–#Rt–1). (p. 105). Empirically, this suggests that the coefficient
on per capita income in standard growth regressions
This also has the advantage of being symmetric, so may itself be influenced by the current account, as
that a decomposition of ŷ t1 –ŷ t2 (that is, where country/ explained below.
region 2 is used as the reference) will provide the same The empirical specification of the above model
breakdown as that for ŷ t2–ŷ t1 (where country/region 1 consists of two simultaneous equations for the current
is used as the reference). This is the decomposition account and for growth. In equation (1), growth in
formula used here. per capita income in country i in year t, $yit, depends
on lagged income relative to the steady-state income
level, (yit–1 –y*t–1). The steady-state income level, y*t, is
allowed to change over time, but is assumed to be the
Modeling Financial Integration and same for all the countries in the sample. If poor coun-
Growth in the EU tries grow faster as they converge to income levels of
their richer neighbors, then the coefficient on lagged
This section provides a brief description of the model relative income should be negative. Here, this “speed
of financial integration and growth in the EU, which of convergence” coefficient consists of two parts: a
was used in Section VI of the main text. Within this part that is influenced by the current account, A2 cait–1,
group of countries there is a clear link between growth and an independent part, A1t. If current account defi-
and current account deficits, with higher growth being cits (cait <0) accelerate income convergence, then the
associated with larger current account deficits, both coefficient A2 should be positive. The specification
over short one-year horizons and over longer periods also allows for the possibility that the current account
(Figure A3). The best-fit line suggests that an increase influences actual growth directly, and this effect is
in the current account deficit of 2 percentage points captured by the terms A3 cait–1. In addition, growth
of GDP is associated with a 1–1.4 percentage point is allowed to be influenced by standard neoclassi-
increase in GDP growth. Deviations from the best- cal growth controls, that is, schooling and population
fit line are also informative, as they show that some growth, that are denoted by matrix Z1,it. The growth
countries are growing rapidly at present without incur- equation is thus
ring significant external liabilities, while others could
be expected to grow faster given the level of the cur-
rent account (or conversely, that they should have a $yit = x+(A1t +A2 cait–1)(yit–1–y*t–1)
lower current account deficit given their present growth +A3cait–1+A4Z1,it, (1)
rates).
Theoretical models suggest, however, that this rela- where x is the steady-state growth rate, often associated
tionship is bidirectional and complex. Current accounts with the rate of technological progress in the literature.
are affected by the level of per capita income, with Finally, actual growth is allowed to be influenced by
lower levels of per capita income associated with cyclical factors that may change from year to year.
greater external borrowing. In addition, Blanchard and For this reason, equation (1) is augmented by a year
Giavazzi (2002) note that the growth rate of income dummy, Dt, which equals one in year t and zero other-
can also affect the current account, as it is an indicator wise. The equation can be rewritten as
of future growth prospects, and also captures cyclical
effects of output movements on the current account.
$yit = A0t +(A1t +A2 cait–1)yit–1+A3cait–1
But current account deficits also affect growth, in two
ways. Most obviously, external borrowing removes +A4Z1,it +(v1i +E1it), (2)
constraints on investment and consumption. An addi-
tional effect is suggested by open-economy versions where the term A0t =x–A1t y*t–1 +A5Dt, and (v1i +E1it) rep-
of the neoclassical growth model, as elaborated, for resents a mean-zero composite error term.
47

APPENDIX
Figure A3. Current Account Balances and GDP Growth in the European
Union, 2000–04
10
2004 Sweden
Germany Finland
5 Netherlands Belgium
Current account balance
(In percent of GDP)
Denmark France
Austria Slovenia
0 Italy Poland
United Kingdom Ireland
Slovakia
Spain
–5 Greece
Portugal
Czech Rep. Lithuania
Hungary
–10
Estonia
Latvia
–15 0 1 2 3 4 5 6 7 8 9
GDP growth
(In percent)
10
2000–04 Average
Sweden Finland
5 Belgium
Netherlands
Current account balance
Denmark United Kingdom

(In percent of GDP)
Germany France
0 Italy Slovenia Ireland
Austria Poland Slovakia
Spain
–5 Czech Rep. Lithuania
Portugal Greece Hungary
Estonia Latvia
–10
–15 0 1 2 3 4 5 6 7 8 9
GDP growth
(In percent)
Sources: IMF, World Economic Outlook; and Penn World Tables.
Equation (3) describes the dynamics of the current more and rich countries to lend more, then one would
account. The current-account-to-GDP ratio in country expect the coefficient on relative income, B1t to increase
i in year t, cait, depends on the current level of income, over time. As in standard specifications, current growth
yit, on current growth, $yit, and on the dependency also enters the equation, both as a predictor of future
ratio, denoted by Z2. Other things equal, a country with income and in order to capture cyclical effects of output
a relatively high dependency ratio is expected to save movements on the current account. The effect of growth
less. on the current account is also allowed to vary over time.
Finally, as in the growth equation, the equation has a
cait = B1t (yit – y*t) +B2t$yit +B3Z2,it . (3) common time effect, captured by the year dummy, Dt.
The equation can thus be rewritten as:
The specification is largely standard, except that the
effect of income per capita on the current account is cait = B0t +B1t yit +B2t$yit +B3Z2,it + (v2i +E2it), (4)
allowed to vary over time, following Blanchard and
Giavazzi (2002). If the process of increasing financial where the term B0t = –B1t y*t +B4Dt, and (v2i +E2it) repre-
integration in Europe enabled poor countries to borrow sents a mean-zero composite error term.
48

Appendix
Table A7. Growth and Current Account Deficit Regressions
Current Account
Growth Equation Deficit Equation
Log of per capita GDP1 –4.76 –10.52

[4.17]*** [4.86]***
Schooling 0.25
[2.59]***
Population growth –0.06
[0.22]
Current account deficit 3.68
[3.25]***
Log of per capita GDP * CA deficit –0.39
[3.31]***
Old-age dependency ratio 0.08
[2.02]**
Growth of per capita GDP1 0.12
[0.51]
Number of observations 503 503
R-squared 0.49 0.52

Note: For ease of exposition, the table presents results in terms of the current account deficit rather than the
current account balance. Absolute value of z-statistics in brackets. *, **, and *** indicate significance at 10 percent,
5 percent, and 1 percent levels, respectively.
1The coefficients on income and on growth are time-varying. For these variables, the table shows the parameter
estimates for 2004.
The estimation method used is three-stage least where the “ˆ” superscripts denote estimates. For each
squares, a standard technique for the estimation of period t, the matrix of prediction standard errors is
simultaneous equations in the panel data context. This denoted by st. The standard errors are computed using
method, first proposed by Zellner and Theil (1962), the following formula:
permits the estimation of a system of equations, }}
where some of the explanatory variables are endog- st = xtVx't , (7)
enous. Here, both the current account and growth are
explanatory variables and are endogenous. The three- where xt is the matrix of right-hand-side variables up
stage least-squares procedure uses an instrumental to and including period t, and V is the estimated vari-
variable approach to produce consistent estimates and ance covariance matrix of the parameter estimates.
generalized least squares to account for the correla- Standard error bands around the predicted values
tion structure in the disturbances across the equations. can then be computed using a band of ±1.96 times
For further discussion of the three-stage least-squares the prediction standard errors. Estimates of the key
approach to estimation, see, for instance, Greene (2003, parameters as well as the predicted current accounts
pp. 405–407). Table A7 presents the estimation results and growth rates can be found in Table A7, the table
based on EU-25 data from 1975 to 2004. in Box 6.1, and Figures 6.3 and 6.4. Further estimation
Once the parameters are estimated, the model can be details, as well as robustness checks, can be found in
used to generate predicted values of the current account Abiad and Leigh (2005).
and growth, along with 95 confidence intervals. These
benchmark values can be compared to actual outcomes
to assess the performance of growth and the current Data Description
account. The (in-sample) predicted values are obtained
using the equations:
The set of countries covered by the study was deter-
mined by the availability of key variables; small coun-
ˆ it = Â 0t +(Â 1t +Â 4 cait–1)yit–1+Â 2 cait–1+Â 3Z1,it
$y (5) tries (with population less than one million) were also
excluded. The global sample of 125 countries that are
in the data set are listed in Table A1. Within this global
ˆ it = B̂0t +B̂1t yit +B̂2t$yit +B̂3Z2,it,
ca (6) sample, we define a group of emerging market countries
49

APPENDIX
the investment price deflator to the GDP deflator, both

Table A8. Emerging Market Economies of which are also taken from PWT. Data for the growth
accounting regressions were taken from Bosworth and
Argentina Israel Russia Collins (2003).
Brazil Jordan Singapore Data on schooling are taken from the Barro-Lee
Bulgaria Korea Slovakia educational attainment data set (http://post.economics.
Chile Latvia Slovenia harvard.edu/faculty/barro/data.html), and are defined
China Lebanon South Africa
Colombia Lithuania Sri Lanka
as the average years of secondary and higher educa-
Croatia Malaysia Taiwan Province tion in the population. For countries not covered by the
Czech Rep. Mexico of China Barro-Lee data set, we regress their data on second-
Egypt Morocco Thailand ary and tertiary enrollment rates from the WDI and
Estonia Pakistan Turkey use predicted values from that regression. Population
Hong Kong SAR Peru República
Hungary Philippines Bolivariana de growth is from the WDI, supplemented when missing
India Poland Venezuela with PWT data.
Indonesia Romania Openness is the sum of exports and imports divided
by GDP, defined as the variable openc in PWT. This
was supplemented by WEO data when missing. Tax
revenue to GDP is taken from several sources, including
the OECD database, the IMF’s Government Finance
Statistics, and the WDI. Partner country growth is from
as those covered by the Morgan Stanley Capital Inter- the Global Economic Environment of the WEO, and is
national Emerging Markets index; in addition, all of calculated as the average of growth in partner coun-
the EU’s new member states and accession candidates tries, weighted by their shares in total exports. The
are treated as emerging market countries. The countries dependency ratio is taken from the WDI, and is defined
included in the emerging market country sample are as the share of the population that is either younger
listed in Table A8. Finally, we identify a subsample of than 15 years or older than 64 years divided by the
21 advanced economies, defined as the set of OECD share of the population that is between the ages of 15
countries that are not in the emerging market country and 64.
subsample. Data were collected in the early part of 2005 Finally, our measure of institutional quality is taken
and so may not reflect more recent revisions. from the International Country Risk Guide, compiled
Income levels and growth rates are chain-weighted by the private consultancy firm Political Risk Services.
real GDP per capita in PPP terms (rgdpch) from Penn This data set covers 143 countries, from 1984 to the
World Tables (PWT) Version 6.1 (http://pwt.econ. present. First used by Keefer and Knack (1997), it has
upenn.edu/). As these data end in 2000 and are sparse become a standard measure of institutional quality in
for the Baltic countries, we supplement and extend the literature, as it has the advantage of both cross-sec-
this using growth rates from the World Bank’s World tional breadth and long-time coverage. The compos-
Development Indicators (WDI) or the IMF’s World ite index is an aggregation of various subcomponents
Economic Outlook (WEO). To analyze the impact of that measure factors such as government stability,
physical capital accumulation we use the relative price democratic accountability, law and order, quality of
of investment, which was found by SDM(2004) to be bureaucracy, and corruption in government. To ensure
more robust than investment share as a growth deter- comparability among countries and over time, points
minant, and which is also less subject to endogeneity. are assigned based on preset questions for each risk
Relative price of investment is calculated as the ratio of subcomponent.
50

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52

Concluding Remarks by the Acting Chair
Growth in the Central and Eastern European
Countries of the European Union
Executive Board Seminar, February 27, 2006
oday’s Board seminar has been a welcome oppor- on the key environmental and policy characteristics
T tunity for Directors to discuss the challenges facing
the Central and Eastern European countries (CEECs)
that will shape the CEECs’ growth prospects. Directors
noted that certain environmental features—including
of the European Union (EU) as they raise living stan- initial income gaps, population growth and aging, and
dards to Western European levels. Directors welcomed historical trade relationships—as well as conditions
the staff’s comprehensive analysis of the CEECs’ recent more subject to policy influence play important roles
growth performance, the policies required to support in supporting growth. Among the latter, our discus-
rapid catch-up, and the vulnerabilities that will need to sion highlighted, in particular, the quality of legal and
be monitored as convergence proceeds. They also made economic institutions, size of government, real cost of
a number of useful suggestions on how the analysis of investment, educational attainment and labor market
these issues can be deepened going forward, including performance, openness to trade, and inflation. While
with some case studies, and looked forward to similar Directors were encouraged that the CEECs do reason-
regional surveillance reviews in the future. ably well in meeting these conditions, they also noted
Directors recognized the difficulty in disentangling that differences tend to favor growth in the Baltics over
the unique forces that shaped the CEECs’ growth over the CE-5, reinforcing other indications that a two-speed
the past 15 years, including the steep post-transition catch-up—rapid for the Baltics, more moderate for the
drop in output, the macroeconomic and institutional CE-5—may be emerging.
reforms related to EU accession, and the benign global Directors agreed that the process of European inte-
conditions in the more recent period. While the CEECs’ gration will play a critical role in supporting a rapid
per capita output growth in the past five years has put catch-up in the CEECs. Substantial transfers from the
them in the upper half of the emerging market com- European Union to the new member states are one
parator group—with the Baltics among the top five per- obvious benefit, but potentially more important will be
formers—Directors cautioned that the continuation of the benefits from closer institutional, trade, and finan-
these rapid growth rates cannot be taken for granted. cial integration with Western Europe. In this regard,
Directors noted important differences in the pat- Directors were encouraged by indications that thus
tern of growth in the CEECs vis-à-vis other emerging far foreign savings have contributed significantly and
markets, particularly the lack of employment growth, appropriately to growth in most CEECs, and that the
and the heavy contribution of total factor productivity even large current account deficits of some countries
(TFP) gains. They acknowledged that the convergence have been in line with their growth rates.
experience of other EU members, such as Greece, Ire- Directors observed, however, that alongside the scope
land, Portugal, and Spain, demonstrates the viability of for accelerating the convergence process are the risks
sustained periods of high productivity growth. Never- that increased reliance on foreign savings will generate
theless, they pointed out that the CEECs’ recent TFP significant vulnerabilities in the CEECs. They noted
growth may have been heavily influenced by the elimi- that large current account deficits are a potential source
nation of the inefficiencies of central planning—imply- of increased indebtedness. The use of foreign savings,
ing the possibility of some trailing off in the absence of therefore, needs to be watched closely, and the compo-
strong efforts to improve the business environment. sition of current account deficits—including the extent
Directors emphasized that prospects for the CEECs to which they are caused by reinvested earnings on for-
will depend on how well they do in establishing mac- eign direct investment—deserves careful assessment.
roeconomic and structural conditions conducive to sus- The use of foreign savings has also stimulated rapid
tained growth, which is expected to be based on greater credit growth both for businesses and, especially for
labor use and higher investment rates. They welcomed households that have had little access to credit, grow-
staff’s use of empirical growth models to shed light ing confidence in the future means sizable borrow-
53

CONCLUDING REMARKS BY THE ACTING CHAIR
ing to smooth consumption. In this regard, Directors reducing opportunity unique to the CEECs. They con-
cautioned that, especially in the Baltics and Hungary, sidered that the adoption of the euro by the new EU
various combinations of high external debt ratios, rapid member states should be predicated on a sound macro-
credit growth (with a sizable share in foreign currency), economic basis. This was seen as important especially
and, in the Baltics, low reserve coverage of short-term to allow these countries sufficient flexibility to respond
debt need to be monitored carefully. For the immediate to asymmetric economic shocks in the absence of an
future, Directors were reassured that a number of fac- independent monetary policy.
tors—high reserves in the CE-5, strong fiscal positions Directors considered that assessing the vulner-
in the Baltics, satisfactory competitiveness, relatively abilities associated with rapid catch-up—especially
high standards of transparency, and well-supervised those related to strong capital inflows—will be the
and predominantly foreign-owned banks—help miti- key challenge for Fund surveillance in the CEECs in
gate these vulnerabilities. the foreseeable future. Fund surveillance, Directors
Against this backdrop, our discussion identified a stressed, should encourage policies that are support-
number of policy priorities for CEEC governments. ive of convergence, while closely monitoring accom-
Among them, the need to establish cushions against panying vulnerabilities and helping to keep them
shocks; to contribute to domestic savings appropri- contained. In this regard, several Directors noted
ately through sizable fiscal surpluses when catch-ups that surveillance should focus on core issues related
are rapid; to avoid disincentives to private saving; to to macroeconomic and financial stability and its
support strong financial supervision; to ensure strong institutional underpinnings, while broad institutional
corporate governance and efficient bankruptcy proce- development should remain the domain of develop-
dures; and to increase transparency across the spec- ment banks. Further, it was noted that Fund advice
trum of economic activities. Directors also encouraged should continue to be sensitive to country-specific
authorities to enact policies that will enable early euro factors, while being mindful of the risk of potential
adoption—the growth-enhancing and vulnerability- adverse regional spillovers.
54

Occasional Papers
Recent Occasional Papers of the International Monetary Fund

252. Growth in the Central and Eastern European Countries of the European Union, by Susan Schadler, Ashoka
Mody, Abdul Abiad, and Daniel Leigh. 2006.
251. The Design and Implementation of Deposit Insurance Systems, by David S. Hoelscher, Michael Taylor, and
Ulrich H. Klueh. 2006.
250. Designing Monetary and Fiscal Policy in Low-Income Countries, by Abebe Aemro Selassie, Benedict Clements,
Shamsuddin Tareq, Jan Kees Martijn, and Gabriel Di Bella. 2006.
249. Official Foreign Exchange Intervention, by Shogo Ishi, Jorge Iván Canales-Kriljenko, Roberto Guimarães, and
Cem Karacadag. 2006.
248. Labor Market Performance in Transition: The Experience of Central and Eastern European Countries, by Jerald
Schiff, Philippe Egoumé-Bossogo, Miho Ihara, Tetsuya Konuki, and Kornélia Krajnyák. 2006.
247. Rebuilding Fiscal Institutions in Post-Conflict Countries, by Sanjeev Gupta, Shamsuddin Tareq, Benedict
Clements, Alex Segura-Ubiergo, Rina Bhattacharya, and Todd Mattina. 2005.
246. Experience with Large Fiscal Adjustments, by George C. Tsibouris, Mark A. Horton, Mark J. Flanagan, and
Wojciech S. Maliszewski. 2005.
245. Budget System Reform in Emerging Economies: The Challenges and the Reform Agenda, by Jack Diamond.
2005.
244. Monetary Policy Implementation at Different Stages of Market Development, by a staff team led by Bernard
J. Laurens. 2005.
243. Central America: Global Integration and Regional Cooperation, edited by Markus Rodlauer and Alfred
Schipke. 2005.
242. Turkey at the Crossroads: From Crisis Resolution to EU Accession, by a staff team led by Reza Moghadam.
2005.
241. The Design of IMF-Supported Programs, by Atish Ghosh, Charis Christofides, Jun Kim, Laura Papi, Uma
Ramakrishnan, Alun Thomas, and Juan Zalduendo. 2005.
240. Debt-Related Vulnerabilities and Financial Crises: An Application of the Balance Sheet Approach to Emerging
Market Countries, by Christoph Rosenberg, Ioannis Halikias, Brett House, Christian Keller, Jens Nystedt,
Alexander Pitt, and Brad Setser. 2005.
239. GEM: A New International Macroeconomic Model, by Tamim Bayoumi, with assistance from Douglas Laxton,
Hamid Faruqee, Benjamin Hunt, Philippe Karam, Jaewoo Lee, Alessandro Rebucci, and Ivan Tchakarov.
2004.
238. Stabilization and Reforms in Latin America: A Macroeconomic Perspective on the Experience Since the Early
1990s, by Anoop Singh, Agnès Belaisch, Charles Collyns, Paula De Masi, Reva Krieger, Guy Meredith, and
Robert Rennhack. 2005.
237. Sovereign Debt Structure for Crisis Prevention, by Eduardo Borensztein, Marcos Chamon, Olivier Jeanne,
Paolo Mauro, and Jeromin Zettelmeyer. 2004.
236. Lessons from the Crisis in Argentina, by Christina Daseking, Atish R. Ghosh, Alun Thomas, and Timothy
Lane. 2004.
235. A New Look at Exchange Rate Volatility and Trade Flows, by Peter B. Clark, Natalia Tamirisa, and Shang-Jin
Wei, with Azim Sadikov and Li Zeng. 2004.
234. Adopting the Euro in Central Europe: Challenges of the Next Step in European Integration, by Susan M.
Schadler, Paulo F. Drummond, Louis Kuijs, Zuzana Murgasova, and Rachel N. van Elkan. 2004.
233. Germany’s Three-Pillar Banking System: Cross-Country Perspectives in Europe, by Allan Brunner, Jörg
Decressin, Daniel Hardy, and Beata Kudela. 2004.
232. China’s Growth and Integration into the World Economy: Prospects and Challenges, edited by Eswar Prasad.
2004.
231. Chile: Policies and Institutions Underpinning Stability and Growth, by Eliot Kalter, Steven Phillips, Marco A.
Espinosa-Vega, Rodolfo Luzio, Mauricio Villafuerte, and Manmohan Singh. 2004.
230. Financial Stability in Dollarized Countries, by Anne-Marie Gulde, David Hoelscher, Alain Ize, David Marston,
and Gianni De Nicoló. 2004.
55

OCCASIONAL PAPERS
229. Evolution and Performance of Exchange Rate Regimes, by Kenneth S. Rogoff, Aasim M. Husain, Ashoka
Mody, Robin Brooks, and Nienke Oomes. 2004.
228. Capital Markets and Financial Intermediation in The Baltics, by Alfred Schipke, Christian Beddies, Susan M.
George, and Niamh Sheridan. 2004.
227. U.S. Fiscal Policies and Priorities for Long-Run Sustainability, edited by Martin Mühleisen and Christopher
Towe. 2004.
226. Hong Kong SAR: Meeting the Challenges of Integration with the Mainland, edited by Eswar Prasad, with
contributions from Jorge Chan-Lau, Dora Iakova, William Lee, Hong Liang, Ida Liu, Papa N’Diaye, and
Tao Wang. 2004.
225. Rules-Based Fiscal Policy in France, Germany, Italy, and Spain, by Teresa Dában, Enrica Detragiache, Gabriel
di Bella, Gian Maria Milesi-Ferretti, and Steven Symansky. 2003.
224. Managing Systemic Banking Crises, by a staff team led by David S. Hoelscher and Marc Quintyn. 2003.
223. Monetary Union Among Member Countries of the Gulf Cooperation Council, by a staff team led by Ugo
Fasano. 2003.
222. Informal Funds Transfer Systems: An Analysis of the Informal Hawala System, by Mohammed El Qorchi,
Samuel Munzele Maimbo, and John F. Wilson. 2003.
221. Deflation: Determinants, Risks, and Policy Options, by Manmohan S. Kumar. 2003.
220. Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, by Eswar S. Prasad,
Kenneth Rogoff, Shang-Jin Wei, and Ayhan Kose. 2003.
219. Economic Policy in a Highly Dollarized Economy: The Case of Cambodia, by Mario de Zamaroczy and
Sopanha Sa. 2003.
218. Fiscal Vulnerability and Financial Crises in Emerging Market Economies, by Richard Hemming, Michael Kell,
and Axel Schimmelpfennig. 2003.
217. Managing Financial Crises: Recent Experience and Lessons for Latin America, edited by Charles Collyns and
G. Russell Kincaid. 2003.
216. Is the PRGF Living Up to Expectations? An Assessment of Program Design, by Sanjeev Gupta, Mark Plant,
Benedict Clements, Thomas Dorsey, Emanuele Baldacci, Gabriela Inchauste, Shamsuddin Tareq, and Nita
Thacker. 2002.
215. Improving Large Taxpayers’ Compliance: A Review of Country Experience, by Katherine Baer. 2002.
214. Advanced Country Experiences with Capital Account Liberalization, by Age Bakker and Bryan Chapple.
2002.
213. The Baltic Countries: Medium-Term Fiscal Issues Related to EU and NATO Accession, by Johannes Mueller,
Christian Beddies, Robert Burgess, Vitali Kramarenko, and Joannes Mongardini. 2002.
212. Financial Soundness Indicators: Analytical Aspects and Country Practices, by V. Sundararajan, Charles Enoch,
Armida San José, Paul Hilbers, Russell Krueger, Marina Moretti, and Graham Slack. 2002.
211. Capital Account Liberalization and Financial Sector Stability, by a staff team led by Shogo Ishii and Karl
Habermeier. 2002.
210. IMF-Supported Programs in Capital Account Crises, by Atish Ghosh, Timothy Lane, Marianne Schulze-
Ghattas, Ales˘ Bulír˘, Javier Hamann, and Alex Mourmouras. 2002.
209. Methodology for Current Account and Exchange Rate Assessments, by Peter Isard, Hamid Faruqee,
G. Russell Kincaid, and Martin Fetherston. 2001.
208. Yemen in the 1990s: From Unification to Economic Reform, by Klaus Enders, Sherwyn Williams, Nada
Choueiri, Yuri Sobolev, and Jan Walliser. 2001.
207. Malaysia: From Crisis to Recovery, by Kanitta Meesook, Il Houng Lee, Olin Liu, Yougesh Khatri, Natalia
Tamirisa, Michael Moore, and Mark H. Krysl. 2001.
206. The Dominican Republic: Stabilization, Structural Reform, and Economic Growth, by a staff team led by
Philip Young comprising Alessandro Giustiniani, Werner C. Keller, and Randa E. Sab and others. 2001.
205. Stabilization and Savings Funds for Nonrenewable Resources, by Jeffrey Davis, Rolando Ossowski, James
Daniel, and Steven Barnett. 2001.
Note: For information on the titles and availability of Occasional Papers not listed, please consult the IMF’s Publications Catalog or contact IMF
Publication Services.
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O C C A S I O N A L PA P E R

Growth in the Central and Eastern

Susan Schadler, Ashoka Mody, Abdul Abiad, and Daniel Leigh

INTERNATIONAL MONETARY FUND

©International Monetary Fund. Not for Redistribution

Production: IMF Multimedia Services Division

Please send orders to:

©International Monetary Fund. Not for Redistribution

II Scope of the Study 4

III The Record: Enduring Strengths or a Bounce Back? 6

IV Growth Scenarios: Possible Paths for the Catch-Up 14

V Policies and Long-Term Growth: What Can Be Learned from

VI European Integration: Opportunities for Growth 27

VII Implications for IMF Surveillance 35

Appendix. Growth Regressions and Data Description 39

Concluding Remarks by the Acting Chair, Executive Board

©International Monetary Fund. Not for Redistribution

3.2. CEECs and Other Emerging Market Regions: Growth in Real

©International Monetary Fund. Not for Redistribution

The following conventions are used in this publication:

• “Billion” means a thousand million; “trillion” means a thousand billion.

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

CE-5 Refers to Czech Republic, Hungary, Poland, Slovakia, and Slovenia

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

Figure 2.1. Macroeconomic Trends in the CEECs, 1990–2004

1990–94 1995–99 2000–04

Growth in Real Per Capita GDP Inflation

Private Capital Flows (Net) Direct Investment (Net)

Sources: Penn World Tables; and IMF, World Economic Outlook.

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

Indonesia Peru Turkey

Malaysia Mexico Hungary

Peru Thailand South Africa Russia

©International Monetary Fund. Not for Redistribution

Figure 3.2. CEECs and Other Emerging Market Regions:

Sources: Penn World Tables; and IMF, World Economic Outlook.

Figure 3.3. Employment Rates in the CEECs

Source: IMF, World Economic Outlook.

©International Monetary Fund. Not for Redistribution

Figure 3.4. Contributions to Average GDP Growth

Overall GDP growth Employment Capital TFP

©International Monetary Fund. Not for Redistribution

Box 3.1. Compositional Shifts in Output: Implications for Productivity Growth

Labor Productivity in the CEECs, 1994–2002

Czech Rep. Estonia Hungary Lithuania Latvia Poland Slovakia Slovenia

Total labor productivity

Source: IMF staff calculations.

©International Monetary Fund. Not for Redistribution

Hungary:TFP Growth in the Largest 10 Industries, 1994–2002

Communications equipment 2.9 15.7

Food and beverages 20.0 13.1

Machinery 9.2 8.8