Fiscal spending reforms – if not now, then when?

Am extremely busy recently, hopefully I will manage to start posting a bit more often again…

All four large CEECs that joined the EU in 2004, have had problems with fiscal deficits in excess of 3% GDP practically through their entire history of EU membership. They have seen the Commission Excessive Deficit Procedure applied and have in fact done hardly succeeded in reducing the deficits.

Three of the countries saw high growth in the past year or two, not seen since the mid 1990s. If this boom were accompanied by a counter-cyclical fiscal policy, we would expect governments to use public spending in order to smooth the cycle, and automatic stabilizers should guarantee the primary balance to improve. However no such pattern can be observed.

Precisely when the economies are booming, is the time to sort out public finances - exploiting the high growth would allow this to be done less painfully. But with high levels of optimism, and politically week governments caving in to populist pressures the motivation is lacking. Looking at the graphs below we see that the high GDP growth is by no means met by a reduction of general government primary deficit relative to GDP. The politicians seem to be foregoing a perfect occasion to relatively softly sort out their public finances, to fulfill their EU obligations under the SGP and to prepare to join the EMU. There seems little preoccupation that once growth slows deficits may turn out unsustainable, while the social price of cutting spending will be much higher.
The above argument applies to three of the countries, while Hungary is in deeper trouble mainly because of caving in to temptations to loosen fiscal policy in the past (links below).

As we often emphasize, all EU member states are required to join the EMU. Aside Hungary, the three CEECs breach the Maastricht requirement solely on the fiscal deficit criteria (assuming reasonable central exchange rates for the Czech Republic and Poland which are not in the ERM).

The Czech Republic and Slovakia are in a more favorable situation from one point of view – the public debt, though the demographic outlook is similar to the other two states. The debt to GDP ratio in Czech Republic and Slovakia is well below 40% and thus rather far from the Maastricht requirement of under 60%. In Poland public debt will exceed 50% this year (according to the budget plan, Polish methodology) and there is a strong chance it will keep increasing further. In Hungary the situation is most problematic, as the ration is well in excess of 60% without much prospect to decrease in the near future.
Altogether there does not seem much prospect of the EDP being lifted in 2007 and 2008, for the three countries not in the ERM, while Slovakia, if it continues to be serious about joining the euro in 2009 will be forced to reduce the deficit.


Czech Republic
Growth in 2006 was strong, topping 6% and should continue though perhaps at a slightly slower pace according to Commission forecasts. The Czechs saw growth in excess of 6% for two years in a row - the first years of such growth time since transition begun. In early January this year, the Czech government was finally appointed after a 7 month crisis due to inconclusive election results. Despite this, the parliamentary support of the government remains fragile, what obviously causes any serious fiscal consolidation to be hard to expect.

Hungary
The situation in Hungary is certainly the most troubling of the four CEECs and has been reviewed extensively on this blog (here, here and here) and the cuts will need to be more drastic than in the other countries if a major crisis is to be avoided. Generally the government committed to reducing the huge primary balance deficit starting 2007, but the promised figures have since been questioned (see for instance IMF).
Furthermore growth is slowing down, and expected to slow further which will make the necessary reforms harder to push through given the political fragility which surfaced in 2006.

Poland
The yoy growth rate in 2006 was the highest since 1997 and is expected to increase further in 2007. As for being in the growth phase of the cycle, there seems relatively little preoccupation for the high amount of fiscal spending. Certainly despite the repeated promises to reform the fiscal spending (from the Minister of Finance), there seems little improvement and the support of the rather populist parties seems low. Though a major slowdown is not expected in the coming 2 years, reducing spending will certainly be more painful once the economy is developing slower. Moreover, serious reforms have been postponed (according to government declarations) to 2009 which seems hardly credible given that this should be an election year.

Slovakia
Despite a record of high, accelerating growth since 2000, which reached 6.7% in 2006 and is expected to further accelerate in 2007, the primary balance of the Slovak general government account hardly improved since 2003. Admittedly it is despite the increase last year, the primary deficit remained the lowest among the four states, but as Slovakia is the only of them aiming seriously to join the euro in the near future (2009) much more will need to be done taking advantage of the booming economy.
All graphs: BLUE - GDP growth % yoy, PURPLE - GG primary balance as % of GDP.
Data Sources: Eurostat, Eurostat Euro indicators 03/2005 for data 2000-2001 European Commission estimates/forecasts for Convergence Program Assessments (latest) for 2006 and 2007. For Poland the Eurostat methodology was used (Polish methodology excludes pension reform costs and the primary balance improves) in 2000-2003 2% of GDP was subtracted from the primary balance (Polish methodology) in order to proxy for the costs.

The Maastricht Update (13/01/2007)

The Maastricht Update:


Sources: Eurostat, ECB, EBRD Transition Report 2006 , Inflation 2006m11, Interest 2006m12, Exchange rate up to 12/01/2007. Check post for details.
Note: * - currently not fulfilling MC; (a) Exchange rate criterion value calculated as maximum deviation (+ or -) of the daily exchange rate from reference value in the last two years. The reference value is in case of ERM II countries the central rate, while in the remaining countries it is a two year average of the daily exchange rate from today-2 year to today. (d) value for 2005 – this value is not available monthly; (d) Brackets contain forecasts for 2006 from the EBRD Transition Report 2006. Methodological discrepancies between national authorities and Eurostat in case of Hungary and Poland. In case of Poland this is due to different treatment of pension fund transfers associated with pension reform cost, the Polish deficit calculated according to ESA 95 methodology would be breaching the Maastricht criterion cut-off value; (e) ECB on Estonia: The current indicator represents the interest rates on new EEK-denominated loans to non-financial corporations and households with maturities over five years. However, a large part of the underlying claims is linked to variable interest rates and the claims are subject to a different credit risk than government bonds. Finally, the cut-off value is reported as average( min-max) as three countries have identical (low) inflation rates, but different interest rates which serve to calculate the criterion – the Maastricht Treaty is not clear on how to handle this situation, though it does not affect the conclusion, (x) the secondary market 10-year government bond yield for Romania is unavailable, but upon lending rates, shorter term bond yields and inter-bank interest rates, it is clear the interest rate in Romania is higher then the required by the Maastricht Treaty.

The new edition of the Maastricht Update incorporates two major events within the EU – first of all the enlargement on the 1st of January which saw Bulgaria and Romania join the EU, and the requirement to join the EMU “as soon as ready” is extended to the two states. The second important issue is the fact that Slovenia adopted the euro on the same date, by joining the EMU. Both of these deserve a blog entry, and I will try to insert something asap, as soon as I find some free time.

As for the Maastricht Update itself, it is important to notice a number of issues:
- first the only two countries that at the moment fulfill the inflation criterion are the Czech Republic and Poland – both of which do not express the will to join the euro in the near future. It is left to be observed whether Poland’s track record on low inflation will be upheld under the new governor of the central bank (this also deserves an entry, I suppose). All other countries are well in excess of the cut-off value (calculated upon November 2006 annual inflation values for (1)Malta, (2)Czech Republic and (3) equally Poland, Cyprus and Finland) regardless of the monetary regime adopted. As for the interest rate criterion, only Hungary and Romania exceed the cut-off value, regardless of which way it is calculated (see notes (e) and (x) below Table 1). All countries saw their exchange rates fluctuate within the +/-15% bounds, but noticeably Hungary and Slovakia faced rather high changes (the former a large depreciation mid 2006 and the latter a large appreciation relative to its ERM II central rate). As for government finances, we report official figures for 2005 and EBRD forecasts for 2006, but have enough information to speculate about developments in 2006 and possible developments in 2007. Clearly the largest problems with the deficit cap are faced by Hungary, where 2006 deficit as percent of GDP is perhaps in the two digit area, and will remain high, despite some efforts to bring it down, in the coming years. Poland faces the change of methodology in 2007 which will see its deficit rise possibly above 4% of GDP– despite being merely a change in accounting methodology, the change puts the deficit in excess of the Maastricht criterion. The Czech Republic heads for another year of failing to fulfill the criterion, while Romania and Slovakia draw close to the boundary. Government debt seems well within the 60% GDP bounds for all the countries aside Hungary, which in effect of large deficits may face exceeding it in the nearest future.
Overall the country being the worst performer in terms of the Maastricht criteria is, by far, Hungary. Noticeably most of the problems arise from the blown-up public finances – immediate effects are seen in huge deficits and rising debt, while the public spending creates inflationary pressures, and pressures on the exchange rate (admittedly partly to the increased perceived risk of the country) and consequently the interest rate.

Maastricht Update – launch

We decided to provide indication on how the CEECs perform according to the EMU entry criteria laid down in the Treaty of Maastricht which entered into force on 1/11/1993. The idea is the indicators to be regular (for instance monthly) – but lets see how it works ;)

The Maastricht Criteria:
Inflation – annual inflation (of CPI) rate no higher than the average inflation rate in 3 EU Member States with the lowest inflation + 1.5% points;
Interest Rate – long-term interest rate (10 year government bond rate) no higher than average of interest rates in 3 EU member states with the lowest inflation +2% points;
Exchange Rate – (against euro) for two years to remain within +/-15% of the pre-established central rate;
Fiscal deficit – of general government not higher than 3% of GDP*;
Public debt – not higher than 60% of GDP*;
*some additional relaxing provisions apply.

The Maastricht Update:

Sources: Eurostat , ECB , EBRD Transition Report 2006 .
Note: * - currently not fulfilling MC; (a) Exchange rate criterion value calculated as maximum deviation (+ or -) of the daily exchange rate from reference value in the last two years. The reference value is in case of ERM II countries the central rate, while in the remaining countries it is a two year average of the daily exchange rate from today-2year to today.
(b) The decision for Slovenia to enter the EMU was already made, so its performance is just for comparative reasons; (d) value for 2005 – this value is not available monthly; (d) Brackets contain forecasts for 2006 from the EBRD Transition Report 2006. Methodological discrepancies between national authorities and Eurostat in case of Hungary and Poland; (e) ECB on Estonia: The current indicator represents the interest rates on new EEK-denominated loans to non-financial corporations and households with maturities over five years. However, a large part of the underlying claims is linked to variable interest rates and the claims are subject to a different credit risk than government bonds.

Central Eastern Europe and the “Flat” Tax - a follow up

The issue of flat taxes in CEECs has been given wide attention, including posts on this blog (see Taxes – linear or not?), though (as we mentioned in the previously cited post) for a number of reasons the arguments in favor of “flat” taxes in the CEECs are rather anecdotal than backed with theoretical analysis or empirical facts.
A September IMF working paper (IMF WP/06/218) by Keen, Kim and Varsano attempts to fill part of this gap, by looking at the principles and evidence on the rationale behind flat taxes (admittedly putting more weight on the principles than the evidence).

They start of from (justly) underlining the key issue of the "flat" taxes in the CEECs - as we claimed in the blog, they are actually rather progressive than flat. The presence of any sort of tax-free threshold (TFT) causes a tax system with a linear tax of A% above that level, to be in fact nothing different from a progressive tax scheme with two income groups: (1) income TFT where income-TFT is taxed at a A% rate. This complicates the deduction at source (as individuals may receive income from more than one source, See box 1 here) and therefore the largest benefits of a pure linear tax cannot be reaped. In general the only country (from our sample) with what can be labelled a pure flat tax is Georgia, while Russia and Ukraine being relatively close to such a system for two reasons - one the TFT is rather low, and second, it disappears for individuals who exceed a certain income - facilitating at least some types of deduction at source.
An interesting point is mentioned about social contributions is that social secutrity contributions and their 'loose' link to future social security payments may (and in practice do) seriously distort the 'flatness' of taxes.
Consequently we will use the nomenclature of the paper and distinguish a ‘pure flat tax’ from a ‘flat tax’ – the latter being a more broad definition encompassing the systems in the sample (see table 1).

Next, the authors draw a distinction between what they call two waves of flat tax introductions – the first wave, pursued by the Baltics in the 1990s tended to set tax rates at rather high levels, close to the highest rates of the previous progressive tax while in the later wave, starting from Russia, PIT rates were set close to the lowest pre-reform tax rates, thereby leading to a reduction of the marginal tax rate for most income groups.
One thing they seem to omit is the fact that these two groups are in a sense converging – PIT rates are being reduced in Estonia and Latvia, while being increased in Ukraine. Further the countries differ on the approach to CIT, dividend tax, capital income tax, VAT and TFT (except for Latvia and Georgia the TFT was raised during the tax reform).
Aside the detailed review of the reforms, the authors focus on analyzing the principles of flat taxes. They discuss whether a flat tax can be ‘optimal’ from the point of view of balancing efficiency costs to incentive distortions against the benefits of some redistribution (and find that it may not, but also that nothing guarantees that the progressive systems in place are), whether it reduces the incentives for tax avoidance and tax evasion (and though it seems it should, in principle may also cause the contrary), whether it is politically appealing (and what chances are the switch to flat taxes will be soon reversed). Next they look in detail at the possible effect (in principle and, admittedly slightly less convincingly, in evidence) on the distributional effect between income groups, on work incentives (the changes affect both the marginal and average tax rates and thus results in an ambiguous outcome of the interplay of the income and substitution effects), compliance, ease of administering, simplicity (all of which, surprisingly even the last one, according to a Russian-taxpayer survey seem ambiguous) and automatic stabilizers(where the flat tax with TFT seems to have some potential).

Generally the paper is a comprehensive study of the potential rationale behind flat taxes. It provides arguments why the benefits of flat taxes are not so clear in the first place, and why it is so difficult to analyze the effect of flat taxes that formed part of comprehensive tax reform packages (it is truly challenging to disentangle and identify the individual effects of the reforms in the packages - which were not only often not explicitly intended as revenue neutral, but consisted of: the introduction of a flat tax together with a change in tax rate(s); a change in TFT; widening of the tax base via the reduction of exemptions; general attempts to simplify the tax calculation and payment procedures; reforms in tax collection, monitoring, penalty and enforcement. In many cases this may prove unconvincing if not impossible).
This makes the literature review a very interesting and welcome reading.

To me, however, the “flat tax” remains more of a marketing slogan, used to publicize tax reforms – and to signal a change in the regime and the approach to taxes and market economy in general. This may not always prove a successful mean as it tends to spur the backlash of arguments about its alleged non-progressiveness, and thus the breach of the social contract. This, together with a different (at least perceived) effectiveness of the pre-reform or existing tax systems is probably the reason why the appeal was rather strong in CEECs and rather weak in developed countries. I accept the rationale behind the pure flat tax, but until I see convincing arguments in favour of the flat tax, I am somewhat reluctant to believe why it should be significantly better than any other tax system simplification.

One thing the paper lacks perhaps is some focus on the weight of the income groups i.e. when discussing the potential gainers and looser, it would be nice to see, how many people would fall in each threshold, and also what was the use of tax exemptions. Additionally some rough empirical facts, on how the declared taxable income figures changed, and consequently how the distribution changed once the reform came into life, which would yield some information on compliance – I do not know how available to IMF economists such data can be, but perhaps its worth a try. Admittedly both of these issues could well be material for another paper.

Among minor issues that arise from this report are some corrections that we have made to our table in the Taxes – linear or not? post . Firstly we have inserted the previously omitted post-reform CIT rate in Romania (which is 16%), and noted the existence of the additional total income taxin Serbia, which further strengthened in 2006 and causes the label of a “flat” tax rate an inadequate description of the
Serbian tax system. Thanks to the IMF report we were able to spot these issues and correct them. However the report itself seems to have a problem with the Estonian rates – in 2006 the PIT rate in Estonia is 23% as is the rate (not 24% as the report claims) and both will be reducing by 1% point a year to reach 20% in 2009. Although the authors focus on the rates before and after the initial reform, they try to provide up-to-date information on tax rate changes - however some issues seem to go unnoticed – the reduction of Lithuania’s PIT rate from 33% to 27% on the 1 of July 2006 and its further planned reduction in January 2008 to 24% (according to the Lithuanian Ministry of Finance ), Russia’s decrease of the CIT rate to 24% in 2002 and Ukraine’s increase of the PIT rate from 13% to 15% which is due January 2007.
Most of these have been already the table under the “old” post, but we repost a more legible excerpt from the table here:
Table 1. Tax rates in “flat tax” CEECs (updated table) as of 2006.
Sources: see (primary table), IMF(2006),
Notes: (a) 0% rate on retained earnings, paid out earnings tax at 23%, decreasing 1%point a year to 20% in 2009; (b) decreasing 1% point a year to reach 20% in 2009; (c) decreased to 27% on 01/07/2006, will decrease to 24% on 01/01/2008; (d) Serbia has an additional total income tax for income above a threshold (which decreased in 2006) thus is basically not a “flat tax” regime; (e) will increase to 15% 1/01/2007; (f) standard rate, (g)the TFT only exists up to a certain level of income.

What is the future for Central Eastern European equity markets?

Today, in light of the discussion on the possible emergence of a new trading platform ('Banks plan to rival European exchanges' in FT 15/11/2006 ) which caused some stir-up in the major European exchanges, I would like to turn to smaller, regional equity markets, whose members will probably not be, at least primarily, of major interest for the founders of the above projects. To initiate a series of blog entries, I would just like to present some numbers on the CEEC stock markets and compare them to other European equity trading floors. In some time a note on the evolution of CEEC equity markets should follow, and something more formal on the degree of comovement.
Thus I would like to go back to reviving the idea of a unified trading platform which would incorporate existing equity markets of Central and Eastern Europe. As we have shown (by now illustratively, but some proper evidence will come) on this blog (here) there seems to be quite a high degree of comovement of stock market indices in the major CEECs.

Table 1. Main market size of equity markets in CEECs and selected EU comparisions.
Sources: Federation of European Securities Exchanges, OMX, Bucharest SE, Sofia SE.

Generally, as can be seen from Table 1 the CEEC equity markets are rather small. The largest, the Warsaw Stock Exchange is of roughly comparable size with the Wiener Boerse. Low trade volumes and thus a rather illiquid market make equity a rather rare source of financing, especially in the case of SMEs. Total market capitalization (including foreign companies, though admittedly it does not make much difference, as of end of October 2006) is rather small compared to GDP (2006) and ranges from under 10% in Slovakia an Bulgaria to over 30% in Poland and Slovenia, while trade volumes in the entire region are roughly 150% of those in the Wiener Boerse.
The Riga, Tallinn and Vilnius stock exchanges already form part of the OMX Nordic Exchange Group, which seems a wise decision, as the size of local markets generates a rather high information cost for investors. Over 80% of Baltic stock is traded over OMX, and the capitalization of domestic OMX traded firms relative to GDP ranges 10-30%.
However concerning the rest of the countries, a common platform of the Budapest, Prague and Warsaw exchanges, would quite probably boost the importance of the market, and potentially the inclusion other equity markets (like Bratislava, Ljubljana, Sofia or Bucharest) would strengthen the role of the new platform.
A common trading platform (something like the Euronext, or OMX) would allow better access to capital, and thus raise the importance of capital financing. Clear, uniform regulation, easy and transparent comparison of the developments would allow the reduction of costs both on the issuers and investors side, and thus boost efficiency. Of course a common equity market would increase the access to capital (by providing access to investors in all of the participating markets) but more importantly would improve the access of smaller investors to a more liquid, richer market, by reducing the cost of participation.
This of course is not easy – it would require strong determination especially in issues like supervision coordination (or a common supervisory authority), but as we see from the example of the Baltic States, a common platform is not nearly an impossible prospect.

The small, illiquid markets do not seem to have much future on their own – though of course it is not improbable that some of the existing markets will join formations like Euronext. Moreover the idea of a common platform for the region is obviously not a new one - initiatives from Wiener Boerse, Deutsche Boerse (e.g. NEWEX ) have however not been very successful (see see the work by Claessens for an overview). But as long as for medium firms listing in large Western equity markets is costly, and listing in the local exchange does not provide proper access to capital this niche could be exploited by a common platform. In reality, actual IPOs in the region are quite often highly oversubscribed, thus it would be the opening up of the access of investors to a wider range of investment possibilities, which could prove more important. Finally the increased size and liquidity of the market could attract firms that previously did not consider a public offering.
Generally, a common Central Eastern European equity market seems a rather appealing idea.

2006 - The European Year of Workers (Im)Mobility

As the EU is currently still celebrating the year 2006 as the European Year of Workers’ Mobility it may be a good idea to review what restrictions on intra-EU mobility still apply towards the CE-8, and how this celebration is reflected in declarations on the opening up of the labor markets towards the 2007 two candidates – Bulgaria and Romania.

Upon the previous (1/May/2004) enlargement of the EU, labor market restrictions were an individual decision of each member state. The restrictions could sum up to a maximum of seven years, after which the workers from CE-8 will have to be treated equally with workers from the old member states (which should happen in mid 2011 at the latest). On the day of accession only three states (Ireland, Sweden and UK) opened up their labor markets, while other countries retained their permit systems, though admittedly with some changes, be it instant or gradual, in the way they are issued. After a two year period (1/May/2006) another four countries (Finland, Greece, Portugal and Spain) decided to adopt the ‘open-door’ policy, and two months later, Italy notified the Commission that it is doing the same. The rest of the countries do not seem to be moved by the ‘2006 Year of Workers’ Mobility’ slogan and is keeping the permit schemes, though admittedly the ‘toughness’ of the restrictions varies among countries. Notably, Italy is the only EU founding member that has decided to open up its labor market.
As for the new enlargement, to come next year, the declarations seem even more severe. The leaders of the previous open-door policy seem a bit overwhelmed by the influx of workers from the CEEC-8, which well exceeded estimates, and thus the UK was the first country to declare (Eastern approaches, FT: October 25 2006) it will not extend its policy to Romania and Bulgaria. With similar voices from Ireland, it is hard to expect the more conservative (on the 'open door policy') states will not follow, especially the ones with restrictions still applying to the previous group of acceeding countries. The threats of reciprocity on the side of the candidates will probably have no influence on the other member states (as for instance Poland and Hungary have been applying the rule since accession).
On the other hand, the CEEC-8 states do not seem to give a fabulous example themselves. When joining the EU in 2004 they jointly decided not to restrict labor market access to each other. Now, there seems to be less consensus. The Estonian, and then the Slovak government declared it will not apply any restrictions (here) and were recently followed by a similar declaration from Poland (here, in Polish unfortunatelly ). The other countries seem rather undecided, Hungary seeming rather against the idea (here). Politically, this seems to be a mistake, as one can still recall the complaints on the decisions of most EU-15 countries to seal up their markets against CEEC-8. Moreover, the open-door policy towards Bulgaria and Romania would be rather a signal than have a huge effect on the CEEC-8 economies.
Whatever the outcome will be, the labor markets inside the EU are still far from open to EU citizens form transition economies.

Labor market restrictions information source: EURES

Bulgaria and Romania - a green(?) light

Last week (26th of September) the European Commission gave a green light to the 2007 enlargement which will encompass the two South-East European states. This followed a discussion on the suitability of the countries in question, be it on grounds of relative poverty, the state of economic and political reforms or on the issue of fighting organized crime. Bulgaria was the one to create most controversy, especially on the last issue, and the warning voices from the EC suggested that the issue may lead to the postponing of the enlargement, either for Bulgaria itself or for both of the countries. Though the enlargement has yet to be approved by national parliaments (most have done it already), it seems decided that the enlargement will take place in 2007, amid voices that delaying the accession may have a rather negative than encouraging effect on reforms in the two states.

There are two (among others of course) interesting discussions related to the above discussion. First of all, one concerning the opening up of job markets to immigrants from the above countries, and second, the fact that the EC mentioned that further enlargements will not follow for a rather indefinite horizon.

As both issues seem a bit worrying, I think it is good to start from clearing up a few matters on the first one. The idea to open up to Bulgarian and Romanian workers is even more controversial that in case of the previous enlargements (which could have been easily foreseen (here ), as the countries are poorer than the current NMS. It seems quite probable that the only country to continue its open-door policy to new(est) member state workers will be Finland. The other EU-15 states are reluctant to give a green light to labor mobility. Even the UK and Ireland are most likely not going to continue the stance they maintained with respect to the CE-8. This decision seems politically motivated – the UK had experienced an inflow of 470 thousand workers (estimates including self-employed workers range up to 600 thousand - Home Office Report), mostly from Poland, in the past 2 years – much larger than previously expected.

But the UK has been the primary EU job target for young Polish workers long before Poland actually joined the EU, while this has not been the case of Romanian or Bulgarian workers. Romanians rather choose Italy or Spain – because of language and cultural reasons, geographical vicinity, but possibly also because of the inefficiency of authorities in the crackdown on illegal labor (Christopher Condon reported on this for the FT on the 29/08/06 in “Romanians set sight on Italy and Spain” ). Moreover, quite likely most Romanian migrant workers are already working in Italy and Spain, though mostly in the grey zone. Some estimates (like the Romanian Labor Ministry cited by the previous FT source) claim 2 million Romanians are already working in the EU – 2 million of a 22 million country – so how many more could realistically leave? Of these, 90% are estimated to work illegally. Even if these guesstimates give rather the upper bound, other surveys tend to show ca. 1 million (cited in Migrating or Commuting....) of which 53% illegal. As for Bulgaria, the situation is a bit different. The language similarity is nor an issue, but the country experienced a massive outflow of migrants in the early 1990s (official figures cited in ILO International Imigration Paper no.39
show about 480 thousand net emigrantion in 1988-1995, and here surveys show a decline in population of 6% between 1992-2001), most of them to Germany, Austria, Italy and Spain (and US). Thus in both cases the answer to the question whether Romanians and Bulgarians would flood the EU-15 labor markets upon entry seems to be – no, they’re already there.

Whether the UK opens up to Romanians and Bulgarians – will probably not change much in the UK labor market – as mentioned, the UK would be unlikely to become a primary target for Romanians, and moreover its low-skilled labor market is rather saturated by workers from CE-8. That is, I would claim the large wave of influx into the UK has peaked, and a couple thousand workers from the south of Europe would not change much.

But a decision not to do so (i.e. open up) in Italy, Spain or even France seems rather a mistake. Putting aside the fact that opening labor markets would spread the migration more evenly across the EU15, the EU could benefit as a whole on legalizing the status of ‘underground’ workers from Bulgaria and Romania. Additionally, new EU members will enjoy the right to freedom of movement, and thus coming to an EU15 country as tourist will, contrary to still the current situation (albeit already much easier than a couple years ago) be trouble-free. Therefore one can expect an even additional boost to grey zone employment, especially in Italy, Spain and France. This will not only increase the problem of crime, but also put downward pressure on wages – obviously illegal workers are not subject to minimal wages, and the employer bears no costs of social security or medical insurance. The only wise decision would be to open up, and allow a “coming-out” of the underground workers, which would facilitate the crackdown on crime.

Finally, governments of CEECs are realizing that the outflow of (mainly young, flexible and often skilled) workers may not be so favorable, and we should soon expect incentives in order to attract them back home. Admittedly the recent emigration did contribute to the lowering of unemployment rates in Poland (from above 19% on EU entry to 15.5% in August, though not seasonally adjusted) and other CE-8 countries, but as we discussed thoroughly on this blog ( here ) the outflow of (mainly young) workers may have many adverse longer term effects on the economies. Social security, pension and healthcare systems are put under strain from the lack of contributors, while the amount of beneficiaries is increasing as the societies age (in case of the CE-8 relatively rapidly). The infamous, though possibly frequent case of university graduates (whose education was paid by the tax payer) not being able to find a job at home and thus shifting to low skilled tasks in the UK, means that the money invested in their education could perhaps have been spent better. Health and pension systems, and (in this case rather wasteful) education spending reinforce the already high tax burden on employees in the home countries, which further decreases the job opportunities for young workers – creating something like a vicious circle.
Bulgaria and Romania are growing fast and unemployment rates are not extremely high (8.7% and 7.5% respectively data). Reportedly, some sectors in Poland (despite the still high unemployment rate) like agriculture and construction, but also Romania are reporting a shortage of labor–and during this years’ harvest, there were voices in the Polish government to look east for workers….

Hungary - high time to act

In the past months, many voices have raised the fact of unsustainability of the twin deficits troubling Hungary. Among others, we expressed preoccupation about the build up of the fiscal and current account deficits (fiscal deficit for the year was recently predicted to exceed 10% of GDP, for an overview of the developments see: Hungary - heading for trouble? , Hungary - continuing to head for trouble? , Hungary's new tax increases - a comment). The need for an extensive fiscal reform, especially on the expenditure, but also on the revenue side was emphasized by international organizations (IMF, EU) and by economists and commentators (among others, Zsigmond Járai, the head of the Hungarian National Bank, MNB, FT, The Economist and this blog). We focused on the fact that tax reductions and increases in social spending promised during the recent elections were totally unrealistic. But it still seems some people believed the campaign slogans. Now the government admitted lying about the situation of the economy, and backed out on its promises, but as mentioned above the actual state of the economy was visible for quite some time - the development has hardly come as a surprise.

The need for reform is obvious and urgent. Yesterday (19/09/06) the forint dropped slightly against the euro (1% initially but only 0.7% on closure) and the stock market fell (by 1.2%). A relatively modest downturn, even if we take into account the developments since the beginning of the year (forint down against euro by almost 10% since January, BUX down by 10% since April/May levels), which signals there is hope in the turn around, and that despite the protesters on the street, honest, immediate and complex handling of the situation can steer the country into safe waters. Surely the situation is not simple - the current government openly caught on lying to the public has, many claim, lost legitimacy. On the other hand, it would take substantial time for another one to get elected. The decisions to cut spending and not to reduce (but even increase) taxes, will certainly be highly unpopular – especially after the high-blown promises of the recent election, but are absolutely necessary, though will not guarantee a safe exit. In the medium term, I don’t think a further fall in the forint and the BUX can be avoided, however, there seems to be room to escape a crash. The falls from the beginning of the year suggest investors may have been more reasonable with their expectations than the voters – expecting that the fiscal cuts must come, and therefore perhaps being also more ready to welcome them.

The developments in Hungary had limited effect on the markets in the region – the Czech Korona and the Polish Zloty barely moved (albeit downwards) closing respectively -0.2% and -0.4% against the euro. The PX and WIG also tipped downward, but again, not spectacularly.

Generally, I think the effect of contagion should be rather modest, albeit negative – Poland and the Czech Republic have budget deficits, which ought to be reduced, have pending campaign promised spending, but all of a more reasonable order.
The Baltics, despite their strong external exposure through current account deficits, contrary to Hungary have sound fiscal policy. They would be hurt by a flight of capital from the region, but this seems rather unlikely, as the situation in Hungary was bold and identified some time ago, and its troubles were more evident and in many cases different than in the other CEECs. However, the sooner the situation in Hungary is resolved, the better for the region.