Real convergence in the CEECs, euro area accession and the role of Romania.

• Author: Szeles, Monica Raileanu
• Position: Central and Eastern European countries - Report

1. Introduction

   The paper has an empirical focus, namely to measure the state of regional convergence of the ten new EU member states (EU10) stemming from the former Communist regime, i.e. Bulgaria, the Czech Republic, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, Slovenia and Slovakia. This list sums up all the countries that acceded to the EU in the last two phases of enlargement, with the exception of Cyprus and Malta. We left the two smaller countries intentionally out of the research focus, as they were established democracies long before their accession to the EU and they also don't share the particular traits of the Eastern bloc. Our paper contributes to the growing literature in the field, including the two new additions to the EU, namely Bulgaria and Romania, which were often omitted in previous studies concerning convergence. We believe that in the context of an enlarging EU and EMU, the empirical investigations of regional convergence become increasingly important.

   Subsequently, the paper follows to point out the importance played by Romania in the achievement of absolute and conditional convergence in the CEE region. The general macroeconomic context in Romania is approached and particularly detailed before and during the financial crisis.

   Despite of the impressive number of empirical studies aimed at stating absolute and conditional convergence in the EU at different stages of its enlargement, the literature on regional convergence in the CEE is still poor and divergent at some points. Since the CEE countries share a number of common peculiarities arising from their communist roots, the regional convergence might be an issue of interest, also in the light of the future participation of the CEE countries at the EMU.

   The analysis of GDP growth and its determinants is approached in a longitudinal perspective and uses panel data models which are applied on a period of 11 years. To get robust results, but also to allow including endogenous explicative variables of growth, several estimation methods have been compared, in the framework of the fixed effects regression models.

   The paper is structured as follows. Section 2 surveys recent literature on convergence in the EU and EMU region with a particular focus on Romania. Section 3 describes the methodological framework used for investigating conditional convergence among the EU10. The data, variables and model are presented in section 4. Section 4 also includes recent developments of the financial crisis and its effects on Romania's efforts to stay on the path of real convergence. Section 6 comprises our main conclusions.

2. Literature review

   The ten transition countries analysed in this paper have undergone profound changes once they abandoned the centralised economy and embarked on their journey to becoming market economies. Officially, transition was considered to be over once these countries were allowed to enter the European Union. Still another important challenge lay ahead: the adherence of these states to the euro area, which officially implies the fulfilment of the Maastricht (nominal) convergence criteria. To date, just two of the EU10 countries, namely Slovenia and Slovakia joined the euro area. Many economists are wondering though whether these two and the remaining of EU10 are sufficiently prepared for the real convergence process.

   At present, the fulfilment of nominal convergence criteria in a sustainable manner is necessary for the participation of a new EU country in the EMU, while the real convergence is strongly needed for the sustainable development of the enlarged European Union in the long term. Also, in the context of EMU enlargement, the real convergence allows the EU monetary policy to be effective for all countries.

   Before examining the actual stage of the nominal and real convergence in the EU and within its regions, the causal relationship between nominal and real convergence could provide insights to their importance in the assessment of progress made in the European integration process. The empirical evidence (Lein-Rupprecht et al., 2007; Lein et al., 2007) indicates that the process of real convergence influences the process of nominal convergence or price level catch up with the euro area, through the channels of productivity growth and trade openness; i.e. openness has a negative impact and productivity growth a positive one. Other papers (Smidkova, 2001; Herrmann and Jochem, 2003) study the compatibility between nominal and real convergence and find supportive evidence only in some EU countries.

   The enlargement of the EMU toward the CEECs has been extensively approached in the literature. Bergs (2001) made an early assessment of the Central and Eastern European (CEE) countries prior to their EU accession whether they are truly prepared for the EMU, besides the Maastricht criteria, stressing the role of regional and cohesion policy in this respect. The same question was approached by Bjorksten (2000), who analysed real convergence in the enlarged euro area, by means of case studies (Greece, Portugal, Ireland), as well as in the states of the USA and Canada. Figuet and Nenovsky (2006) investigate to what extent Romania and Bulgaria are able to adopt the common economic (and above all monetary) policy of the EU, and to what extent the convergence to the EU stimulates the economic development of these countries. They analyse the degree of nominal, real and financial convergence and synchronization of the economic cycle with that of the European Union, using the unconditional // convergence approach. The panel consisting of four economies (Bulgaria, Romania, Czech Republic and Hungary) carried the result that Bulgaria was advancing faster at that time than Romania towards its integration into the common dynamic of the European economy, showing more convergence.

   A part of the literature considers that CEE countries should not rush to join the euro even if they meet the nominal criteria (see Orlowski, 2001, Kocenda et al., 2005) but rather wait until real convergence according to the Optimal Currency Area (OCA) theory is well under way (Rinaldi-Larribe, 2008). The latter study, which is based on business cycle synchronisation shows that adopting the euro too early and following a policy of fiscal consolidation, in order to control inflation, will induce a risk of slowing the growth trend and the economic catch-up of these countries.

   Another part of the literature (e.g. Rostowski, 2003) advocates that a sooner joining of the euro area would benefit the interests of CEE countries and disapproves the conflict between nominal and real convergence, as it was pointed out by various authors (see De Grauwe and Schnabl, 2004). De Nardis et al. (2008) study the euro effect on trade integration and find a short run intra-Euro zone pro-trade effect, following the adoption of the single currency. This finding also supports a sooner adhesion to the EMU.

   Still, other authors, such as Dragan and Pascariu (2008), by analysing the Romanian-EU convergence argue that Romania should not rush in or slow down, but rather try to choose the appropriate moment to enter the euro area.

   Overall, the results in the literature on nominal and real convergence are mixed. Besides different sample periods and country coverage, the divergences in results appear to be driven by different methodologies. Traditionally, two main definitions of convergence have been used in the literature: [beta] convergence, which implies a negative correlation between the growth rate of per capita GDP and its initial level, for a given cross-section of countries, and [sigma] convergence, which implies a reduction in the dispersion of per capita GDP within a sample of countries.

   As mentioned in the EU Treaty, the economic and social cohesion must balance the economic growth. In this light, the study of regional disparities becomes particularly important. At a country and regional level the sigma convergence's analysis confirms a reduction of disparities over time while the beta convergence--regarding per capita income, employment and productivity--also applies for almost all EU territorial aggregates (Lein-Rupprecht, 2007; Marelli, 2007).

   Kowalski (2003) analysed nominal and real convergence in alternative exchange rate regimes in CEE countries and their implications for EMU accession, while Frankel (2004) studied real convergence in the CEE countries based on trade patterns and cyclical correlations. Kocenda et al. (2005) made an examination of the nominal and real convergence of the 2004 ten new EU members with a broader approach to fiscal and inflation convergence. Their results indicate slow but steady per capita real income convergence, significant inflation and interest rate convergence, but a lack of fiscal convergence. Lein-Rupprecht, Leon-Ledesma and Nerlich (2007) assessed the empirical relevance of real convergence on nominal convergence for new EU member states and showed that productivity growth has had a positive impact and openness a negative one on price level convergence with respect to the euro area. The determinants of growth and of the catching-up process in CEE countries were summed up by Arratibel et al. (2007), who investigated convergence by means of a production function approach. Their conclusion was that the real convergence process is far from finished.

   More recent studies included Romania and Bulgaria in the examination of convergence to the EU or the euro area, again by using different sets of variables or country samples, with interesting results.

   Bojesteanu and Bobeica (2008) assessed the degree of business cycle synchronization between the newest member states and the euro area. Their results demonstrate that there is a common business cycle in the euro area and that most of the candidate countries exhibit convergence with this group, with the remarkable exception of Estonia, Lithuania, Slovakia and Romania. Arratibel, Furceri...